This post was contributed by our Financial Literacy Movement partner Ally Bank.
The rates that come with certificates of deposit (CDs) can be enticing, because they’re usually higher than the rates you’ll find for a savings or money market account. However, to get higher CD rates, you have to abide by a specific set of rules. But once you know these rules, you can make CDs work in your favor for reaching your savings goals.
Higher CD Rates Require a Long-Term Commitment
A CD usually offers a set interest rate in exchange for keeping your money on deposit for a predetermined length of time. Generally, the longer the term, the higher the APY (annual percentage yield). And with most CDs, there is a penalty for withdrawing your funds before your account matures.
While this can work as a built-in incentive to stay the course and get the most out of your money, getting that CD rate also requires you to plan ahead before committing your funds. You may want to keep additional funds in a more accessible savings product, like an online savings account, for such needs as your emergency fund.
Do Your Deposits Require Flexibility?
Some people are comfortable purchasing CDs with terms of one year, two years or even five years, but these plans might not work for everyone. If you need flexibility, but still want to take advantage of the higher CD rates, you can opt for a shorter CD term. While the rate on a 1- or 2-year CD may be lower than the rate on a 5-year CD, even that lower rate will almost always beat the rate on a money market or savings account.
Not All Long-Term CD Rates Are Good
It’s also important to look into your CD’s APY. The issuing bank determines the APY — the effective annual rate of return — by factoring in your account’s compound interest rate (assuming you don’t make any withdrawals before maturity). The more often the interest is compounded, the faster your balance will grow. Some banks offer CD compounding monthly, others daily.