So you've finally decided to start your emergency fund so that you've got extra cash for a rainy day. Now you just need to decide where to put the money, since hiding it under your mattress isn't the greatest idea. Understanding the differences between high-yield savings accounts and certificates of deposit can help you make smarter choices with your money.
Liquidity refers to how easily you can access the money in your account. With a high-yield savings account, you can generally withdraw the money at any time without paying a penalty. With a CD, you have to leave the money in the account until the CD matures. Taking money out early results in early withdrawal penalties. These penalties typically average three months of interest if the CD has a term of one year or less or six months if the CD has a longer term, according to Bankrate.com.
The interest rate that you receive on your CD or high-yield savings account will depend on the amount that you put into the account, as well as how long you can commit to leaving the money in the account. The more money you can put in to either type of account, the more likely you'll be able to get a better interest rate. In addition, with CDs, the longer you can leave the money in the account, the higher your rate. According to Bankrate.com, if you select a term of one year or longer, you're likely to get a higher rate with the CD than with a high-yield savings account.
Generally, once you've opened a CD, you're locked into that interest rate for the life of the CD. For example, if you open a CD for five years at 3 percent, that's the interest rate you've got for the entire term. If interest rates fall to 2 percent, you're sitting pretty because you're still earning 3 percent. However, if they rise to 4 percent, you're stuck with the lower rate. With a high-yield savings account, your interest rate can change whenever the bank decides to do so. This is helpful if interest rates rise, because your rate will also go up. However, if interest rates fall, you'll wish you had locked in you rate with a CD.
Each year, you have to pay taxes on the interest that you earn, even if you can't access the money yet. For example, assume that you earn $1,000 on your high-yield savings account and therefore owe an additional $300 in federal and state income taxes. If you need to, you can take the money out of the high-yield savings account to cover the taxes. Conversely, with a CD, if you earn $1,000 of interest, you generally can't tap into the CD's funds, even to pay taxes, without incurring a penalty.
Both CDs and high-yield savings accounts are covered by deposit insurance provided by the Federal Deposit Insurance Corporation. This protects your money in case the bank goes under. As of 2012, the FDIC insurance up to $250,000 per bank and per ownership category. Ownership categories include individual accounts, joint accounts and retirement accounts. For example, if you have a CD and a high-yield savings account in your name only at the same bank, only the first $250,000 would be covered.
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- What Is a Certificate of Deposit & How Does It Work?
- How to Buy a CD in an IRA Account
- How to Reinvest an Interest Certificate of Deposit