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THE FINE PRINT

For the first time in years, bank CDs are worth it

With rates likely to rise more, when is the right time to lock in your investment?

For the first time in years, conservative savers can earn a substantial return on a certificate of deposit.Wipas - stock.adobe.com

What a difference a year makes. Last year about this time, certificates of deposit were generally earning less than 1 percent in interest. But now many banks are advertising CDs that pay more than 4 percent, and they may well rise higher in coming months. People who are looking for safe places to invest can earn a very respectable return by putting cash into a CD. And given the rocky performance of stocks and mutual funds over the past two years, an investment that guarantees a gain is increasingly attractive to some people. Not enough to keep pace with inflation, but an appealing alternative as mutual fund retirement accounts erode.

There’s little mystery about why interest rates on CDs have surged to some of the highest levels in more than 10 years. Confronted with rapidly rising prices on everything from food to energy, the Federal Reserve steadily ratcheted up its benchmark interest rate this year.

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It’s a strategy devised to bring down inflation — which hit a 40-year high in 2022 — by cooling down the economy. A happy byproduct for savers is an impressive hike in interest rates on CDs and other savings accounts.

There is no direct relationship between the Fed rate and CD interest rates. But, historically, interest rates on CDs have tended to rise and fall with the Fed rate.

Here’s what to know about CDs:

Q. What are the basics?

A. Like traditional savings accounts, CDs are bank deposits. What’s different about CDs is they must remain on deposit for a certain period. With a regular savings account, you can withdraw your money at any time without financial penalty (and you must accept a lower interest rate for the ability to do so). But with a CD you commit to not withdrawing your money for an agreed-upon term. If you nevertheless insist on withdrawing your money, the bank will impose a penalty.

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Q. How much of a penalty?

A. The penalty varies from bank to bank. Make sure you understand the terms. But generally you can expect to pay at least three months of interest. The penalty may depend on the length of the CD’s term and how long the CD has been open before you make a withdrawal. Some banks may also tack on a fee.

Because of these penalties, it’s not advisable to use CDs as your emergency fund.

Q. How long are the terms for CDs?

A. Banks generally offer CDs for terms ranging from three months to five years. CDs of less than one year are considered short-term; CDs of four years and longer are long-term (those in between are midrange).

Q. Are interest rates higher on longer-term CDs?

A. Banks usually offer higher interest rates on long-term CDs. You basically get paid more in interest for leaving your money with your bank for longer periods. But it doesn’t always work that way. Banks are free to offer whatever rates make good business sense to them. The objective of banks in increasing CD rates is to pull more money into their coffers. Banks, of course, use those deposits to make loans at higher interest rates than they are paying on CDs. That’s one way they make money.

Q. Under what circumstances would banks pay higher rates on short-term CDs?

A. That happens when banks think interest rates on borrowing are heading south. Banks don’t want to get stuck paying relatively high interest rates on long-term CDs if interest rates on borrowing go down. That would cost them money. Selling short-term CDs gives them more flexibility to keep in sync with changing borrowing costs.

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Q. What should savers consider when choosing between short- and long-term CDs?

A. It’s pretty much the same guessing game on whether interest rates are going up or down. For savers, buying CDs at today’s relatively high rates may make sense if you anticipate rates staying about the same or going down. You’ll be patting yourself on the back for locking in a bunch of long-term 4 percent CDs if rates drop to 3 percent or lower. But a drop is not likely to happen soon.

Q. What happens if interest rates continue to go up?

A. You won’t be feeling so good owning long-term CDs paying 4 percent if banks begin offering them at 5 percent or higher. In the early 1980s, when inflation was rampant, interest rates on CDs topped 15 percent.

Q. How do I shop for CDs?

A. Banks and credit unions are advertising aggressively. One place to start looking is the bank where you already have a checking account or other account. A few websites worth checking are depositsaccounts.com, nerdwallet.com, and bankrate.com.

The Federal Deposit Insurance Corporation headquarters in Washington, D.C.Andrew Harrer/Bloomberg

Q. How safe are CDs?

A. CDs are a favorite of retirees because they are safe. CDs opened at FDIC-insured banks or credit unions backed by the National Credit Union Administration are guaranteed by the federal government. You won’t lose your money if your bank or credit union fails, as long as you’re within deposit limits. And unlike the stock market, they can never lose their face value.

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The FDIC’s standard insurance amount is $250,000 per depositor, per insured bank, for each of several account ownership categories.

Q. Do I need a minimum deposit?

A. Most banks require at least $500 to $1,000 to open a CD, though some have no-minimum-deposit requirements.

Q. Are my earnings taxable?

A. Yes, interest earned in 2022 is taxable income on your 2022 state and federal tax returns, which must be filed on or before April 18. (April 15 falls on a Saturday in 2023; April 17 is Patriots Day, a holiday in Massachusetts.) If you have a CD that spans two or more years, you must pay taxes annually on each year’s earnings. Banks will send statements of interest earnings (IRS form 1099-INT) at the beginning of the new year.

Q. What is a CD ladder?

A. It provides flexibility while investing in long-term CDs. You begin by buying five CDs, each with a different term, from one year to five years. When the one-year CD matures, roll it over into a five-year CD. Repeat for the next four years. After five years, you will have a long-term CD maturing once a year. That gives you access to cash annually while earning interest on long-term CDs (which usually pay more than short-term ones).

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Q. What alternatives are there to CDs?

A. Many banks offer high-yield savings accounts and money market accounts that pay interest rates somewhat close to those of CDs. The advantage of these is that you are allowed to make at least some withdrawals without penalty. But there may be requirements such as maintaining a minimum balance or having direct deposits. Money market accounts may also offer debit card and check-writing privileges.

Q. What about online banks?

A. Online-only banks sometimes offer higher rates in part because they don’t have to spend money on brick-and-mortar branch offices.

Q. What’s the difference between interest rate and annual percentage yield?

A. Annual percentage yield — known as APY — factors in compounding interest. APY is slightly higher than the interest rate because it includes the interest you earn on the interest you have already earned during the term of your CD.


Got a problem? Send your consumer issue to sean.murphy@globe.com. Follow him @spmurphyboston.