My local bank offers me a savings account yield of 0.3% currently. I can get an online savings account rate as high as 2.45%. Or I can get online CD rates as high as 3.25%. The spread here is only 0.8%. Let’s dive into which options is best. Should you open an online savings account or lock your money up into a CD?
I selected Popular Direct, an online bank for these examples. They offer among the highest CD and savings account rates.
It’s worthwhile to point out that all of these accounts are guaranteed. If the bank goes under then the government would step in with their insurance and bail you out. You wouldn’t stand to lose any money with either account type.
Savings Account Rates
Popular Direct offers an online savings account at a rate of 2.36% which is among the highest rates I could find as of 2/2019. The only other higher rate was with CT Bank at 2.45%. By comparison, my local credit union had a savings rate of only 1.5%.
You would need a $5,000 minimum deposit and the account otherwise doesn’t have any fees associated with it. You can deposit as much money as you want. It’s worth pointing out that some accounts have a maximum amount you can deposit. This is often written in the fine print, somewhere.
Potential Profits in Savings Account
If you deposit and initial sum of $100,000 then you can expect to have a profit of $12,511 after 5 years. I chose 5 years as an arbitrary time period so that we can compare it to a CD. In fact, I suspect that the rates in a savings account might go up year-after-year which would only increase your potential profits.
An added benefit to a savings account is that you can take the money out from Popular Direct and transfer it to a higher yielding online savings account. This flexibility is referred to as a liquidity premium. You pay for this by accepting a lower yield (2.36 vs 3.25).
CD Account Rates
The CD rates from Popular Direct are maxed at 3.25% and you would need to stash your money for at least 5 years. There is a minimum but that’s irrelevant since we’ll be far exceeding it with a $100,000 deposit.
This money is also insured and you can open multiple accounts and therefore deposit as much as you want, while enjoying the insurance protection for these accounts.
If you invest $100,000 then you can expect to have $117,344 by the end of the 5 years. That’s a profit of $17,344 which is $4,833 more than what you’d have from the savings account. But again, you would lose the liquidity of such an account.
If you take your money out of a CD early, you’d stand to lose all of your gains. This is referred to as a penalty. Almost never would you lose any of the principal, but still shitty.
Real Life Example
Let’s compare a CD to a savings account using $300,000. The reason I am using this number is that it’s a more realistic amount of what you’ll invest as you get closer to retirement. This would be your fixed asset portion of your portfolio. You hopefully would have some money invested in the securities market as well – such as in a VTI fund.
$300k in a CD Account
Imagine you have $300,000 saved up and invested in a CD or a savings account. From the examples above you could have a profit of $52,000 after 5 years of your money invested in a CD. With that 3.25% rate you would have $9,750/year or $812/month.
You would pay taxes on this as if it was earned income. So if you don’t have any other income other than this $9,750 for the year then you would pay no federal income taxes and likely no state income taxes.
Once the CD term expires you can take the money and roll it over to a high-yielding CD or do whatever else you want with it. Otherwise you can’t do anything with it for that 5 years.
$300k in a Savings Account
If you invest $300k in a savings account with the APY (annual percentage yield) from the example above, you would have a total profit of $37k after 5 years. Or, if we calculate it for 1 year, you would have a profit of $7,080. This comes out to $590/month.
Good news – the money wouldn’t be locked up. You can transfer it anytime you like. If a better opportunity comes up then you can take some or all of it and transfer it to a higher yielding account.
Inflation poses the biggest risk to any fixed asset – but more so with a CD which is locked up. If inflation rises rapidly over the 5 years when you have your money locked up, your actual profits will drop. Imagine that the APY is 3.25% in year-1 and the economy experiences an inflation of 3%. That means the value of your money will only go up by only 0.25%.
What about the savings account? Well, if inflation goes up and your savings account yield doesn’t then you can take your money and move it – no penalty, no delay. That’s the advantage of a savings account. And with a current difference of only 0.8% between an online savings account and a CD, the liquidity premium doesn’t seem worthwhile to me.
If you still prefer CD’s then one option is to create a CD ladder. The topic is dry and complicated so head over here to read more about it.
Fixed Income Investing
CD’s and savings accounts are ‘fixed income investments’ – just like a bond fund. As in, the yield on them is set. This makes them an ideal complement to a stock portfolio. You can take on the volatility risk of the stock market while enjoying the predictability of a fixed income investment.
Your asset allocation will and should adjust as you get older. That’s when you might move more of your money into fixed income assets and away from volatile equity funds.
Some investors think that CD’s have magical powers. They don’t. There is nothing great about a CD unless they offer you a worthwhile return which makes up for the liquidity premium you give up in a savings account. This is very similar to investing in stocks versus real estate. Do the returns in a real estate portfolio make up for its lack of liquidity? If not, then you’re better off investing in the securities market.