High-Yield Savings Account vs. Certificate of Deposit: Which is Better?

If you have money that is currently sitting in an account and not invested, you can start earning interest on that money by utilizing a high-yield savings account or a certificate of deposit (CD). Both options will provide an attractive rate of return and allow you to start earning interest on money that is currently unproductive. As such, these are great options if you currently have excess money in a checking account or traditional savings account.

High-Yield Savings Account

A high-yield savings account is exactly as the name implies. It is a savings account that provides a much greater interest rate than traditional savings accounts. Not all banks offer high-yield savings accounts, so if your bank does not have one, you will want to consider opening an account with another bank. If you have an existing credit card, check to see if your credit card provider offers a high-yield savings account. For example, Discover, Capital One, and American Express all offer high-yield savings accounts. The benefit of opening an account with your existing credit card provider is that the account creation process will be quick and simple. All your personal information is already on file, so the effort to open the account is minimal. You may still prefer to open a high-yield savings account with another bank if the interest rates are more attractive.

Pros of High-Yield Savings Accounts

High interest rates: while the interest rate of a high-yield savings account varies over time based on the interest rate set by the Federal Reserve, as well as other economic factors, it is substantially higher than a traditional savings account. As of 2023, rates hovered around 4.5% as opposed to a fraction of a percent for traditional savings accounts.

Withdraw money anytime: high-yield savings accounts provide flexibility. You can withdraw your money at any time without penalty. A few accounts have minimum balance requirements to earn the best interest rates. However, there are so many options available, I recommend finding one with no minimum balance requirement.

Cons of High-Yield Savings Accounts

Accessibility: many of the high-yield savings accounts available are offered by banks who operate primarily online. This lack of brick-and-mortar locations allows the company to lower operating expenses, allowing them to offer higher interest rates. For the account holder, you may find it more challenging to deposit and withdraw cash. However, this is only a minor inconvenience, as you can electronically transfer the funds to your normal checking account when you wish to make a withdrawal, then go to your normal bank location to pull out the cash.

Interest rate variations: For all its benefits, one of the downsides of a high-yield savings account is the variations in interest rates. This can benefit you when rates are increasing, but if interest rates decrease, you will be subject to those changes. This is the downside of being able to withdraw your money at any time. As a result, you are not locked into a set interest rate.

Withdrawal limits: while you are not limited on the dollar value of your withdrawals, you may be limited on how many times during the month you can make a withdrawal. For example, the bank may limit you to six (6) withdrawals per month. In general, this should not be an issue because the high-yield savings account is not intended to be utilized in the same way as a checking account. As such, you should only need to remove money periodically.

Certificates of Deposit

CDs offer enticing rates of return. A CD works by contributing a set amount of money for a designated period. For example, you may choose to open a 24-month CD with $1,000 at an interest rate of 5%. You are required to leave this $1,000 in the CD for the full period or pay a penalty for early withdrawal. As such, you should only allocate money to a CD that you will not need access to during the designated period. When selecting your CD, you typically have the option to receive the interest payments or allow the interest to accumulate. If left to accumulate, you will take advantage of compound interest (earning interest on the interest already received). In most cases, it is best to let the interest compound. If interest rates have increased substantially since you opened the CD, then it could make sense to invest the interest in another investment type, rather than leave it in the original CD.

Pros of Certificates of Deposit

Fixed interest rate: when you open a CD, it will have a specified interest rate. Interest rates increase based on the duration of the CD. Therefore, you can expect a 36-month CD to pay a higher interest rate than a 24-month CD. However, you should consider the increase in interest rate compared to the additional time your funds will be unavailable. Typically, there is a breaking point among the CD durations where the increase in interest compared to the increase in duration is minimal. For example, if a 12-month CD earns 4%, a 24-month CD earns 5%, and a 36-month CD earns 5.25%, the additional quarter of a percent in interest may not be worth your funds being unavailable for an additional 12 months.

Low risk: CDs are very low risk. Your money is insured by the Federal Deposit Insurance Corporation (FDIC) up to $250,000. This amount is per account holder at the bank. If you had two CDs valued at $150,000 each, then $50,000 would not be insured. Therefore, if you have over $250,000, it may be worth spreading your money across multiple banks.

Cons of Certificates of Deposit

Limited flexibility: when you open a CD, your money is locked in for a specified period and at a specified interest rate. This can be reassuring because you can predict the exact amount that will be earned. However, it also means you will be unable to utilize the money for another purpose should an opportunity arise. Additionally, if interest rates continue to rise, you will be locked in at the rate at the time you obligated the money.

Early withdrawal penalty: if you need to take out your money before the maturation of the CD, you will have to pay a penalty. Consequently, ensure you have an emergency fund available to cover such expenses to avoid accessing your CDs early. The high-yield savings account is an excellent choice for your emergency savings.

Conclusion

Both high-yield savings accounts and certificates of deposit offer numerous benefits. A high-yield savings account allows you to withdraw money at any point, earn an interest rate substantially greater than a traditional savings account, and take advantage of increases in interest rates. However, that also means the interest rates will decrease when interest rates decline. Typically, the easiest way to add or remove funds from a high-yield savings account is to link it to your checking account and make electronic transfers. Another option to passively earn interest on money that is currently in a checking account or traditional savings account is purchasing a CD. CDs are low risk and provide a fixed rate of return that is not subject to fluctuations. As such, you can accurately predict the exact interest that will be earned over the entire period. The downside is your CDs are locked in for a set period and withdrawing money before the CD matures will incur a penalty. While a high-yield savings account can benefit all consumers by replacing their traditional savings account, whether a CD is appropriate is dependent on your savings goals, willingness to accept risk, and how long the money can be invested.