certificate of depositWhenever you’re thinking of saving some money, there’s usually always a question of whether you should open a savings account or a Certificate of Deposit (CD). While both accounts have their benefits, a CD may be a better bet if you’re planning to save larger amounts of money, as it may earn you more interest over time. Not sure what a CD is? Here’s what you need to know.

What is a Certificate of Deposit?

A CD, while not technically a savings account, functions somewhat similarly to one. Essentially the depositor is given a “certificate” or promissory note from a bank, credit union or other similar financial institution that states the deposited funds will earn interest for a pre-specified amount of time or term. While the interest rate (or APY) is set by the institution, the account’s term is typically chosen by the depositor. Terms do, however, fall within a specific range (e.g. three months to five years), and almost always must be intervals of three or six months. Your financial institution will generally give you a list of terms it offers to select from as well as conditions under which the CD will operate. Generally the longer the term, the higher the APY.

What are the advantages of CDs?

CDs are in a sense the best of two worlds, as they allow for higher APYs while providing the stability and safety of a savings account. Almost all investments follow a risk-reward relationship where the higher the return, the more risky the investment or vice versa, but CDs somewhat subvert this, as they are not only FDIC insured, but are also term-locked with fixed APYs. This means that if interest rates decrease, your CDs will still compound at the stated initial rate for the duration of the term. Finally, CDs are also renewable, which means you can hold your money in the account indefinitely and roll it over into another term. Because of this equal risk, higher reward dynamic, CDs can sometimes make more sense than simply leaving your money in a regular savings account.

What are the disadvantages of CDs?

The biggest disadvantage with CDs is that the depositor is required to trade off flexibility for higher interest rates. Because CDs require set terms, money cannot be disturbed for the entirety of the term unless you’re willing to pay penalties or completely close out the CD, which also requires you to pay a penalty. In addition, money cannot be added to an existing CD. While there are exceptions with penalty-free CDs, those yields are so small that it’s usually better to open a savings account. Since CDs are seen more as a longer-term investment than a savings account, they also require a minimum deposit that’s relatively higher than most savings accounts.

There are a few caveats to some standard features as well. For example, make sure you verify with your bank the technical terms of your CD. While all of the CDs we review are fixed rate, other banks might offer variable CD rates and it’s up to you to make sure you understand what you’re getting into. Lastly, beware of auto-renewal options, which means once the CD has matured, it will automatically roll into a similar-term CD. Although an auto-renewal might save you some time, it could also cost you money if you’re not careful enough, as the new CD may have a lower interest rate. To avoid this potential loss, you’ll want to make sure that you mark your calendar for when your CD term is nearly up. That way, you can call or visit your bank and evaluate what you’d like to do. Even though managing CDs is a more passive affair than managing a savings or checking account, you’ll want to make sure you’re still on top of what’s happening to your money.

When should I open a CD?

Typically when you have some money that you can put aside for a while and not have immediate plans for, a CD isn’t a bad option. In most cases, a CD will outcompete a savings account when it comes to long-term saving. Of course a CD could never replace a savings account, as a CD cannot be used for emergency funds or building balances like you can with a savings account. Basically, CDs are ideal when you want to do long-term investing with a modest amount of funds without making a riskier investment.

Read our savings accounts reviews to see which banks offer CDs, and follow our online savings blog to get more information on how these banks work.