Certificate of Deposit (CD) vs. Checking Account: Which Should You Open?

When it comes to managing your money, keeping large sums of cash on you at all times is generally not considered wise. About 95% of American households include at least one person with a bank account, according to the Federal Deposit Insurance Corporation (FDIC).

Although they are just two of the possible account types offered by most banks, checking accounts and certificates of deposit (CDs) are good places to keep funds, although they each have their own quirks. By understanding these differences, you can more easily decide which one is best for you or if you want both.

Key takeaways

  • A CD earns interest over time with the expectation that the funds deposited will remain intact for months or years.
  • Checking accounts are liquid. They allow frequent deposits and withdrawals.
  • The FDIC and National Credit Union Share Insurance Fund (NCUSIF) insure deposits of up to $250,000 in checking accounts, savings accounts, and CDs at most banks and credit unions.

How a Certificate of Deposit (CD) Works

A certificate of deposit (CD) is an interest-bearing time deposit account that offers a fixed interest rate premium in exchange for a commitment to leave the money untouched for a specified period of time. Think of a CD as a kind of loan from a bank. The bank borrows money from the customer and pays interest for the privilege.

While almost every bank and credit union in the country offers CDs to their customers, the terms remain at the bank's discretion. This includes the length of the term and the amount of interest it will earn. Typically, short-term CDs pay a fraction more than a savings account. The longer the term, the higher the interest.

Important

Checking accounts, savings accounts and CDs are automatically insured by the government up to $250,000 in losses.

Advantages of a CD

  • Interest accumulates over time: Generating interest over time is an easy way to earn passive income. Since the main idea is to leave the money in a CD intact, banks and credit unions offer higher interest rates for longer terms. CD interest rates can be several times the national average, if you're willing to commit your money long enough. As of August 2022, the “best” one-year CD rates ranged between 2.50% and 3%. For the three-year CD, rates were around 3% to 3.1%.
  • Fixed interest rates: Most CDs come with fixed interest rates. Regardless of what happens in the financial world during the life of the account, the bank cannot increase or decrease the rate. This is good and bad: an account will never see its earnings decrease due to a drop in interest rates, but it will not see greater returns if interest rates rise. Yet you will know exactly what you will get. Variable rate CDs are available but carry their own risks.
  • Helps prepare for future expenses: CDs are great for long-term planning, like saving for a new car or a down payment on a house. By putting the money aside for a few years, you can ensure you don't use those funds for other expenses, as well as calculate how much extra money your CD will earn in interest.

Disadvantages of a CD

  • Funds are not easily accessible: The greatest feature of a CD is the fact that you're supposed to keep your hands out of your cookie jar for a set amount of time. Whether you agreed for several months or several years, this money should be considered out of reach.
  • Early withdrawal is punishable by law: Withdrawing money from a CD before it reaches maturity comes with a penalty imposed by the federal government. The exact amount of the penalty depends on what is stated in the account agreement. Keep in mind that the law sets a minimum sentence but no maximum limit.
  • Inflation can wipe out interest gains: Nobody likes inflation, but CD owners are particularly affected by the phenomenon. If the national inflation rate exceeds a CD's interest rate, you get back less money in terms of real purchasing power than you expected when you deposited the money.

How a checking account works

If a CD means not having access to your funds for a set period of time, checking accounts are the exact opposite.

Offered by virtually every bank and credit union in the United States, checking accounts are highly liquid deposit accounts designed for regular deposits and withdrawals.

Checking accounts can be accessed in several ways, including automated teller machines (ATMs), electronic debits, debit cards, or paper checks. Financial institutions typically offer a range of account types, including student checking accounts, business or business checking accounts, and joint accounts.

Advantages of a current account

  • Access your money when you need it: Customers can make numerous unlimited withdrawals and deposits without any risk of penalties. With multiple ways to access funds, checking accounts make it easier to pay for everyday expenses in addition to large purchases.
  • Various types of accounts: Checking accounts come in different types, each with their own features, limits and benefits. If you need a checking account, chances are there is an account to suit your specifications.
  • Set up direct deposit: Thanks to direct deposit, the days of receiving and cashing a paper check for your paycheck are over. By simply filling out a few quick documents with your employer, your funds can be deposited directly into your checking account. In most cases, the money is available to use on payday.

Disadvantages of a checking account

  • Zero interest: Most checking accounts don't earn interest, so keeping large amounts of money in one won't earn any returns. You'll probably want a second account that earns interest.
  • Account fees and minimums: Checking accounts generally have account fees and minimums. From overdraft fees for spending more money than you have in your account, to ATM fees for withdrawing money out of network, to monthly service fees to keep your account running, Banks charge these extra costs as a way to generate revenue.
  • It's easy to overspend: It's easy to overspend and not pay a check. Fortunately, most banks offer online applications that allow their customers to check their balance at any time.

Frequently asked questions

What happens to my CD when it matures?

Within a month or two before your CD's maturity date, the bank or credit union will notify you of the impending end date. You will receive instructions on how to tell them what to do with the maturing funds.

Typically, the bank will give you three options: transfer the CD to a new CD at that bank, transfer the funds to another account at that bank, or withdraw the product.

How can I avoid checking account fees?

You can avoid certain fees. Many banks waive some of their fees for accounts with a regularly deposited paycheck. Others waive certain fees if a minimum balance is maintained.

Do I have to pay taxes on a CD account?

Yes. Interest income earned on certificates of deposit is subject to income tax. Since CD interest income is taxed as income, the percentage of tax you'll owe depends on the tax bracket of your overall income.

The essential

Whether you opt for a checking account or a CD, the decision comes down to how much access to your money you want or need. If you need access to most of your funds at any time, a checking account may be right for you. If you are able to live without touching some of your money for a while and want to earn interest along the way, then you should take a look at CDs in your area.



Source link

Scroll to Top