Finance 101: CDs and Savings Accounts

With tax season once again upon us, you may be lucky enough to get a sizeable tax return, and it’s time to start thinking about what to do with that money. You could pay down your business loan or put the money back into your business, or you could invest your money in a savings account or CD in order to earn interest on that money.

In fact, if you’re confident you won’t need to touch that money for emergency purposes over the next few years, a savings account or CD is the perfect way to put your money to work for you. For anyone new to investing, this is a low-risk way to get started.

But what exactly is a CD, and how is it different from a savings account?

Savings Accounts

In a nutshell, a savings account allows you to earn interest on the money you deposit there. Most banks will not penalize you for withdrawing money from a savings account once or twice, but if you dip into your savings account often enough, the bank can change your savings account to a checking account, which means you will no longer earn interest.

The amount of interest that you earn on your savings account is determined by your bank, and the interest rate might go up or down over time. Savings accounts also do not allow you to earn compounded interest, which means you earn interest only on the amount of money you deposit into the account; you cannot earn interest on your interest.

Because savings accounts have few restrictions, they are considered very low risk investments. The downside is that the interest rate for a savings account is also very small. You would need to have a large sum of money in a savings account to be able to accrue meaningful interest.

For many small business owners, this isn’t very practical. Any extra money you have is usually better invested by improving or expanding your business. But there is a compromise in the form of a Certificate of Deposit.

Certificates of Deposit (CDs)

Like a savings account, a CD allows you to keep some of your money separate from your checking account for later use. However, the similarities pretty much end there.

CDs may require a minimum deposit, usually no more than $5,000. However, it’s possible to find some banks or credit unions that do not have such a requirement. You will be expected to keep your money in the bank for a minimum period of time. The shortest time frames are just a few months, and the longest requirements can be five years or more. You can withdraw funds early if necessary, but you’ll be penalized.

CDs are a popular form of investment because they accrue compounded interest. This means you can grow your investment more quickly than in a savings account, because you will earn interest on your interest. You will also receive some protection from the volatile economy, because CDs have fixed interest rates. Whereas the bank could lower your interest rate on a savings account, they can’t lower the interest rate on a CD. However, they also can’t raise your interest rate, and you’ll have to wait until you’ve fulfilled the terms of the CD before you can transfer your funds into a CD with higher interest.

Different Types of CDs

Knowing the basic differences between CDs and savings accounts can help you determine which one is right for you. But it gets a little more complicated when you consider how many different types of CDs there are. Here’s a look at some of the most common:

• Variable Rate CD. Unlike a traditional CD, your interest rate will be subject to change in accordance with the stock market if you have a variable rate CD. With this option, you take more of a gamble that the economy will be favorable overall and give you a high interest rate throughout the life of your CD.
• Callable CD. Traditional CDs last a certain amount of time, known as the maturity date, and you cannot collect your money until that time. With a callable CD, the bank has regular opportunities to pay out your CD early and end your contract. In return, you get a higher interest rate.
• Bump Up CD. One of the main benefits of CDs is also its main disadvantage: your interest rate is locked in. This is good if interest rates trend downward during your CD, but bad if interest rates trend upward, because you miss out on extra interest. A bump up CD gives you one opportunity to change the interest rate of your CD. This is a useful option is the market seems rather unstable.
• Liquid CD. It may give you peace of mind to know that you can liquidate funds from your CD in an emergency without facing huge penalties. A liquid CD gives you that option, which is exceptionally appealing to small business owners as back-up in case of a crisis.
• Add On CD. After a certain amount of time has passed, you can add more money to your CD with this option. However, some restrictions may apply, such as a minimum deposit.

With so many options, you’re bound to find a CD that works for you. However, if you simply don’t want to put too much faith into the financial market, a savings account is a good alternative for keeping extra funds.