Consumers and investors need ways to save or invest money safely for a short duration of time. The two most popular options are the Certificate of Deposits and Savings Account. But which is better?
In this article, you will learn the differences between a CD and a Savings Account and its benefits and disadvantages.
What is a CD
A certificate of deposit (CD) is a type of money market account offering a short-term interest-bearing investment. Financial Institutions provide CDs as a practice to raise funds. CDs are standard for consumers and investors looking to save cash for a short period of time. Because of the time invested, CDs typically offer very low-interest rates in return, yet, are relatively safe investments.
A CD is a promissory note, short-term investment, allowing consumers to earn a fixed rate of interest over a designated period. For instance, Marcus by Goldman Sachs is offering a one year CD at 2.75% APY, Annual Percentage Yield-- the real interest of earnings per year.
This type of CD is also considered a High-Yield CD because it is one of the top rates currently being offered across the financial industry.
Most banks and credit unions offer such short-term instruments as long as the customer can meet his or her initial deposit.
For example, if the minimum deposit for a CD is $500, then the consumer must have $500 to put into that account.
Typically, CDs of $100,000 or more are called Jumbo CDs. Amounts smaller than $100,000 are just referred to as CDs.
Once you purchased a CD, it is locked into an account for a designated period you choose. The longer the period, the higher the rate should be. According to Bankrate.com, a one-year CD national average is earning 0.88% compared to a five-year CD earning 1.44%.
What is the Benefit of a CD
Even though CDs pay a very low-interest rate, the rate is typically higher than a Treasury Bill and a savings account, but are still relatively very low risk.
Also, consumers who make deposits towards a CD with a financial institution must know CDs are FDIC insured up to $250,000, unlike Treasury securities, mutual funds, and stocks.
Below is a sample of CD rates for January 2020 by Bankrate.com.
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What is a Savings Account
A savings account is an interest-bearing account deposited with a financial institution such as a credit union or a bank. Because of the account's safety and liquidity, savings accounts have one of the lowest interest rates.
What is the Benefit of a Savings Account
Savings accounts are a great way to save money if you are looking to park funds for an emergency fund or for cash you may need within less than a year. Because savings accounts are FDIC insured up to $250,000 per account, you can rest assured your money is safe.
Many financial institutions will limit the number of time annually you can make withdrawals from savings accounts. If you pull out more than the limit, the bank may penalize you with a small fee.
Savings Accounts or CD?
When deciding whether to park money in a CD or a savings account, it depends on why you are saving this money. If someone is looking to store cash in a haven for a short period earning little to no interest and do not want to be penalized for making withdrawals from their account, then a savings account may be an option. Please note that many savings accounts have an annual withdrawal limit.
For instance, according to USAA's Service Fee Schedule, the first withdrawal from a savings account is free, but the second withdrawal is subject to a $5 fee. The third withdrawal may be converted to a checking account while closing the savings account as well, as a $5 fee.
A certificate of deposit may be an option if you need to store funds for a short period. As of the date of this blog, a one-year CD National Average rate is 0.88% compared to the national average of a savings account, 0.10%.
Below is a chart of how the two perform against each other based on historical and current rates. CDs can range from one month to five years but also based on the financial institution.
CDs and Savings Accounts are FDIC Insured
Like savings accounts, CDs are FDIC insured up to $250,000 per account. If you have three CDs at $250,000 each deposited into one account, you are insured up to $250,000, leaving the remaining $500,000 at risk.
However, as the FDIC provides coverage "per account," you can deposit each CD into three separate accounts, and the FDIC will insure each $250,000 account, helping to secure your $750,000 investment. Just note that any interest over this limit is at risk.
It also irks me to see banks posting CDs as risk-free investments. From one investor to another, there is no such thing as risk-free investments, not even U.S. bonds. Everything has a risk. The types of risks that CDs face are inflation risk and liquidity risk.
Understanding the Risks of a CD or Savings Account: Inflation & Liquidity
When it comes to investing, your investment always has a risk, and it comes in many forms. The first type of risk you need to understand is Inflation Risk. Such a threat is the loss of purchasing power over time.
Each month, the Bureau of Labor Statistics measures "the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services." Professors have taught in business schools that a healthy rate of annual inflation should be between 2-3% annum. If inflation gets too high, consumers struggle to pay for goods.
In 1917, the United States saw its highest inflation rate of 19.66%! If we saw an inflation spike like this, your $2.24 gallon per gas now would cost $2.68. It may not sound too bad until you consider all of your expenses spiking around 20%. Your credit cards would increase by this amount, if not more. Your investments could no longer keep pace with inflation, thereby losing money.
Inflation causes concerns. Look back at the thriving country, Argentina. It was a coveted place to visit, and the economy was very similar to the U.S. until 1975 through 1990 when inflation spiked over 300%.
Inflation caused prices to double every few months. "Prices rose at an explosive annual rate of more than 1,000% in 1989, before inflation was finally brought under control." This would make your CDs, savings account, and investments practically worthless.
The end goal for all investors is to beat inflation because it eats away at your purchasing power. In the below chart, I have depicted the growth of a CD and a savings account based on current national averages as of the blog's date to help illustrate how inflation will usually beat these two investments.
The chart above provides a clear visual that by investing in a CD, you lose purchasing power by $24.20 over the five years depicted, and this is during regular inflationary periods.
Every year countries strive to maintain growth in inflation rates. This leads to political issues such as raising minimum wages, but in reality, prices indeed remain relatively stagnant.
For example, in 1979, a gallon of gas cost approximately $0.63 per gallon. Sound cheap? Well, adding the inflation rate to this amount to keep prices comparative, an apples-to-apples comparison, the price is around $2.24 a gallon. This price isn't much different from today's prices. Read how inflation impacted the U.S. during the 1970's.
Now had this $0.63 been invested, at the annual inflation rate, you would have felt zero impact. Had you stuffed the $0.63 in your mattress or buried it outside in your backyard, you would be short today and can only afford about a 1/4 a gallon of gas. You are not traveling very far. That is why any investment and money saved, MUST at a minimum, keep pace with inflation.
One of the most critical components of saving money is determining its liquidity. Liquidity refers to the ability to transition an investment, in this case, a CD or savings account, into cash.
When you have money in a checking account, you have quick access to cash. A savings account is also liquid, but depending on the bank's fee schedule, you may be able to withdraw the funds for free the initial time or may be charged a fee. Let it alone; you have access to cash.
A CD is not as liquid as a savings account, but it is still a liquid investment. You will be charged a fee for early withdrawal as well as may be taxed in the future on any interest earned on it.
Unlike owning a savings bond, having a CD or money in a savings account are both very liquid instruments.
To learn about the different types of CDs, visit Bankrate.com.
When purchasing a CD, it is highly encouraged to review the compounded interest schedule. It does make a difference when a CD is compounded daily compared to annually.
When money is compounded daily, it is recalculated helping you to earn interest on interest. Daily compounding makes your money grow faster when compared to the annual compound.
An annual compound is precisely what it is. Your money is calculated once per year, meaning your interest won't earn interest until the following year.
The comparison between a savings account and a CD have similarities and differences. By understanding what your goal is and how soon you need to access your money, will determine whether a CD or savings account is the appropriate investment.
Both are short-term tools, but if you think you need to access the money prior to the CD's maturity date, then a savings account is more appropriate. If you do not need the funds but want to keep it semi-liquid and earn more interest than a traditional savings account, then a CD may be the preferable choice for you.
Nick Carroll is a published author of 6 Steps to Achieve Financial Freedom and has worked as a Commercial Credit Analyst, Investment Marketing Associate, and worked at the Pentagon-Air Force Budget Office. He is a graduate of Creighton University with a Masters in Investment Management and Financial Analysis and holds a Bachelor's in Banking & Finance.