What suits you?
When it comes to managing your money, it’s usually not a good idea to carry large sums of cash with you at all times. Most US households (about 95%) have at least one person with a checking or savings account, according to the Federal Deposit Insurance Corporation (FDIC).
Although they are only two choices from a list of possible account types offered by most financial institutions, checking accounts and certificates of deposit (CDs) are a good place to keep funds, although they have each their own quirks. Understanding these differences will make it easier for you to decide which one is right for you.
Key points to remember
- A CD accrues interest over time with the expectation that the deposited funds will be left untouched for months or years at a time.
- Current accounts are liquid: they allow more frequent deposits and withdrawals compared to other accounts, such as savings and money market accounts.
- The FDIC and the National Credit Union Share Insurance Fund insure up to $250,000 for both types of accounts.
How does a certificate of deposit work
A certificate of deposit (CD) is an interest-bearing term deposit account that offers a fixed interest rate premium in exchange for the customer agreeing to leave the money untouched so that it can mature for a fixed period. Consider a CD as an example where the bank borrows money from its customers; as a borrower, the bank pays its client in the form of regular interest payments.
While nearly every bank and credit union in the country offers CDs to their customers, the terms surrounding each account are at the discretion of the bank. This includes the length of the term and the associated interest rate hike compared to their other products.
Checking accounts and CDs are both guaranteed by the FDIC and NCUA for up to $250,000.
Advantages of a CD
- Accumulates interest over time. Earning interest over time is an easy way to receive passive income. Since the main idea is to leave the money intact on a CD, banks and credit unions offer higher interest rates for longer terms. Interest rates on CDs can reach several times the national average, if you can commit your money long enough. According to the FDIC, the national average rate can be as low as 0.39% for a 5-year CD. Conversely, Goldman Sachs Marcus offers online 5-year CDs at 2.55% APY.
- Fixed interest rates. Once a CD is created, it receives a fixed interest rate. Regardless of what happens during the term of the account, the bank cannot increase or decrease the rate at any time. While this means that an account will never see its earnings diminished due to falling interest rates, it will not see greater returns if interest rates rise. There are floating rate CDs, but they carry their own risks. Still, knowing exactly how much interest your account will accrue gives you an idea of how much you’ll receive when the account matures.
- Helps prepare for future expenses. CDs are great for long-term planning, like saving for a new car or a down payment for a house. By setting money aside for a few years, you can ensure that you don’t dip into those funds for other expenses, as well as calculate how much extra money your CD will earn in terms of interest.
Disadvantages of a CD
- Funds are not easily accessible. The biggest feature of a CD is the fact that you are effectively expected to keep your hands out of the cookie jar for a period of time. Whether you agreed to several months or several years, this money should be considered out of reach.
- Early withdrawal is punishable by law. Although it is not recommended as soon as the account is created, you can withdraw funds from your CD sooner. Withdrawing money from a CD before it reaches maturity carries a federally imposed penalty. The exact amount you will be penalized depends on what is described in the account agreement, but keep in mind that although the law sets a minimum penalty, there is no maximum limit.
- Inflation can wipe out interest earnings. Nobody likes inflation, but CD owners are particularly affected by the phenomenon. If the national inflation rate exceeds the interest rate of a CD, the account could end up losing money in the long run.
How a current account works
If a CD means not having access to your funds for a specified time, current accounts are almost the exact opposite. Offered by virtually every bank and credit union in the United States, checking accounts are highly liquid deposit accounts that allow regular deposits and withdrawals. Chequing accounts can be accessed using several methods, including ATMs, electronic debits, debit cards, or paper checks. Financial institutions typically offer a range of account types, including student checking accounts, business or commercial checking accounts, or joint accounts.
Benefits of a current account
- Access your money when you need it. Unlike savings accounts and other bank offers, customers can make many unlimited withdrawals and deposits without any risk of penalties. With multiple ways to access funds, checking accounts make it easy to pay for day-to-day expenses in addition to major purchases.
- Various types of accounts. Banks generally do not offer a generic current account. In most cases, current accounts are divided into different types, each with its own characteristics, limitations and advantages. Some accounts may offer a limited amount of interest. If you need a checking account, chances are there is one to meet your unique specifications.
- Set up direct deposit. With direct deposit, the days of receiving and cashing a paper check for your paycheck are largely a thing of the past. By simply completing quick documentation with your employer, your funds can be deposited directly into your checking account. In some cases, banks will offer to make your paycheck available up to two days in advance.
Disadvantages of a checking account
- Often irrelevant. Many checking accounts are generally non-interest bearing, so keeping large amounts of cash in one will yield no measurable return. Therefore, you will probably want a second account that earns interest.
- Account Fees and Minimums. Chequing accounts usually come with 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 operate your account, banks will charge these fees supplements as a means of generating revenue.
- Easy passing. For some people, having access to so much money with little effort can be tempting. As such, it’s easy for people to overspend and potentially trigger an overdraft on their account. Fortunately, most banks offer plenty of ways to ensure account holders are notified when they are about to empty their accounts.
What happens to my CD when it matures?
Within a month or two before your CD’s due 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 maturing funds. Typically, they will offer you three options: Transfer the CD into a new CD at this bank; transfer the funds to another account of this bank; or remove the product.
How can I avoid checking account fees?
One way to get free verification is to sign up for direct deposit. Many banks waive fees for accounts with a regularly deposited paycheck. Be sure to check if there is a minimum amount that must be deposited.
Do I have to pay taxes on a CD account?
Yes. Interest income earned on certificates of deposit is subject to state and federal income tax. Since CD interest income is taxed as income, the tax percentage depends on the tax bracket of your overall income.
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 all times, 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, you should take a look at CDs in your area.