5 Things You Should Know Before Opening a CD

As a low-risk investment, a certificate of deposit (CD) offers many benefits. Like a savings account, a CD allows your money to earn interest, it is FDIC insured, and you have a wide variety of CD options to choose from. A CD generally offers higher rates than most savings accounts, but those rates change regularly.

Laura Scharr-Bykowsky is a certified financial planner and principal of a Columbia, South Carolina, financial planning firm called Ascend Financial Planning. She says she “urge[s] clients to have FDIC safe cash reserves, and a CD fits the bill.” She adds that “CDs are attractive now, particularly the longer-term ones, given the current stock market … a CD protects the principal if interest rates change.”

With all the benefits a CD offers, on the surface it appears as though you cannot go wrong with one. There are, however, some factors to consider before opening one up. Performing an analysis of the situation could mean the difference between earning money as planned and experiencing disappointment. Scharr suggests that you examine some of the following details before opening your CD.

1. Options and interest rates

The goal with a CD is to get the highest rate possible, considering your financial situation. Consumers can sort through options using resources such as Bankrate.com or DepositAccounts.com. “They perform a monthly analysis of the best CD rates,” Scharr said.

A concern many investors have about investing in long-term CDs is a rise in interest rates occurring after they lock in a CD rate. Once you open a five-year CD at 2 percent (for instance), you are set at that APY for the entire five-year term. “Ally has a four-year raise your rate CD … the rate is 1.3 percent,” Scharr says. With raise your rate CDs, though, the rates are often lower and they may have other terms attached to them.

These terms could include specific time periods during which you may raise your interest rate, or the CD may be callable (the bank can terminate the CD after a set period of time, such as a year). You also may have to take the initiative and opt to raise your rate, as the bank may not perform a raise increase automatically.

2. When do you need the cash?

A main characteristic of a CD is a term period during which you may not be able to access your money without facing fee penalties. Before obtaining a CD, it’s prudent to examine your current and potential future financial situation. Is it possible you will need this cash within the short term? “If you need the money within two or three years, a high-yield savings account may be the better option,” Scharr advises.

3. Withdraw penalties

If you end up needing the money before the CD matures, “You want to know the penalty — it could be three months or six months of interest,” Scharr said. This depends on the CD’s maturity, she explains.

In some cases, you could end up with less money than you started with. A Bankrate survey found that 92 percent of financial institutions will not only penalize you by taking interest, but if necessary, will also take money out of your principal amount to cover fees.

Some people opt for a liquid CD, which generally offers lower rates. However, it allows time periods during which you may withdraw from your CD, penalty free.

4. Tax rate

The money you earn as interest on your CD is taxable. In many cases, it is taxed at the same rate as your wages. “Those with higher income are subject to a 3.8 percent surtax … they may be better off going with something tax exempt … like a short-term municipal bond fund,” Scharr says.

5. Bank or issuer ratings

It’s a good idea to research various financial institutions. Which one has the highest user ratings? Do you have any experience dealing with that institution? It helps to deal with a financial institution that explains all facets of the transaction clearly, provides good customer service, and expeditiously answers your questions.

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