Bonds versus CDs versus high yield savings: choosing among them

In short

I once watched my neighbor stand at her mailbox, holding two letters from two banks, trying to decide where her savings should sit. If you are holding a similar choice, you are not alone. Start with one plain question: when will you need this money? If you may need it any day, a high yield savings account lets you pull it out, though the bank can change the rate whenever it likes. If you will not need it until a set date, a certificate of deposit, or CD, locks in a rate for that term, and taking the money out early costs a penalty. If the date is far off and you can live with price swings, a bond is a loan to a company or a government, and its price can rise or fall before it comes due. Bank deposits carry federal insurance up to a set limit, while bonds do not. Match the tool to the date. That is the whole game.

The whole of it

What it is

A friend of mine once said that all three of these are just ways of lending your money to someone who will pay you for the favor. He was right, and it helped me. A high yield savings account is a bank account that pays a higher rate than a basic one, and the rate moves with the market. A CD is a deposit with a fixed end date, such as one year or five years, and the bank agrees to pay a set rate until then. A bond is a loan you make to a government or a company. The borrower promises to pay interest and return your original amount, called the principal, on a stated date.

The big difference is where the risk lives. With a bank account or CD, the risk is small, because the deposit is insured. With a bond, the risk depends on who borrowed the money and what happens to interest rates. Different tools, different worries. That is fine.

How it works

You have probably noticed that a rate on a savings account can drop without any warning. That is how a variable rate works. The bank sets it, and the bank can lower it. Your money stays available, but your earnings can shrink. That makes this account a good home for money you may need soon or cannot predict. A CD works the other way. The bank has to pay the rate it promised for the full term, so you know your earnings ahead of time. In return, the bank charges an early withdrawal penalty if you leave before the end date. The account agreement states the penalty, so read it before you sign. A CD fits money with a known date, such as a tax bill or a tuition payment due in two years.

Bonds add one more wrinkle. A bond pays a fixed interest amount called the coupon. If you hold it until it matures, you get your principal back, assuming the borrower pays. But if you sell before then, the price depends on today's market. When new bonds pay higher rates, older bonds with lower rates become less attractive, and their prices fall. When rates drop, older bonds look better, and prices rise. This is why the same bond can be worth less or more than you paid. So a bond suits money you will not touch until the bond matures, or money you can leave alone through a bumpy stretch.

Taxes matter too. Interest from savings accounts and CDs is taxed as ordinary income by the federal government. Interest from U.S. Treasury bonds is taxed by the federal government but is exempt from state and local income tax, according to TreasuryDirect. Some municipal bonds, issued by states and cities, may be free of federal income tax, and the issuer's official statement explains the rules for each one. Always look at what you keep after tax, not only the headline rate.

The numbers, and where to find yours

A person will want a few figures in front of them before deciding. For deposit insurance, the FDIC covers deposits at member banks up to the current figure, which the official source publishes each year per depositor, per bank, per ownership category. The FDIC publishes this on its own site, and it also offers a free tool called EDIE that estimates your coverage. For credit unions, the National Credit Union Administration insures accounts up to the current figure, which the official source publishes each year. Neither agency insures bonds.

For current rates, the best place to start is the bank's own rate page, since rates change often. For Treasury securities, TreasuryDirect posts the latest auction results and rates. For municipal bonds, the Municipal Securities Rulemaking Board runs a free site called EMMA, where you can read official statements and see recent trade prices. FINRA, the brokerage industry regulator, also offers free bond market information for investors. Your own bank statement will tell you your account's current rate, and your brokerage statement will show what a bond is worth today.

A worked example

Let me tell you about a woman I will call Denise. She is 41, and she has $20,000 she will not need for three years. She also keeps a separate emergency fund in savings, so this money can sit. She wants to know what each option might earn, so she runs the math with plain numbers. These rates are made up for the example, not quotes from any bank.

First she looks at a high yield savings account paying 4 percent a year. Her $20,000 at 4 percent earns $20,000 times 0.04, which is $800 in the first year. That rate could change, so she treats the $800 as a guess, not a promise.

Next she looks at a three year CD paying 4.5 percent. Her $20,000 times 0.045 is $900 a year. Over three years, that is $900 times 3, which is $2,700 in simple interest. The bank has to pay that rate for the full term. If she needed the money after one year, she would face the penalty written in her agreement, so she checks that number first.

Then she looks at a bond that pays a 5 percent coupon. Her $20,000 times 0.05 is $1,000 a year. Over three years, that is $3,000. Sounds better, right? But she reads further. If the borrower is a company, it might fail to pay. And if she sold early after rates rose, she might get less than $20,000 back. The extra $100 a year over the CD is the payment for taking that added risk.

Now she thinks about tax. Say her federal rate on interest is 22 percent. The CD's $900 loses $900 times 0.22, which is $198, leaving $702 after tax. The savings account's $800 loses $800 times 0.22, which is $176, leaving $624 after tax. The bond's $1,000 loses $1,000 times 0.22, which is $220, leaving $780 after tax. A Treasury bond would skip the state tax as well.

Denise sees what matters most. Her date is fixed at three years, so a CD that ends in three years fits well. Had the date been unsure, the savings account would have served her better. Had it been ten years away, a bond held to maturity might have made sense. Her answer came from her timeline, not from the highest number.

Where it goes wrong

I have made this mistake myself, so I say it with kindness. People chase the biggest rate and forget the timeline. A CD with a great rate is no bargain if the saver needs the cash early and the penalty eats the gain. The same goes for a bond sold early at a lower price. The borrower may also call a bond early, which means the issuer repays it before the end date. The investor then gets the money back and faces whatever rates exist that day.

Another slip is forgetting the insurance limit. If a person holds more than the FDIC or NCUA limit at one bank, the extra is not covered. Spreading deposits across banks or ownership categories can change that, and the agency's own tool shows how.

A third trap is ignoring inflation. If prices rise 3 percent and an account pays 2 percent, the money buys less each year even though the balance grows. Check your real earnings, not only the stated rate.

Last, watch for fees and fine print. Some bonds are bought through brokers who charge a markup. Some CDs renew on their own at a new rate if the owner does nothing. The account agreement spells this out. Read it slowly.

Questions to answer before you leave this page

When will you need this money, and could that date move on you? If you had to pull it out early, what would the penalty or the price drop cost you? Is the amount you are placing inside the insurance limit at that bank, and have you checked the limit on the FDIC or NCUA site? Do you have a separate emergency fund so this money can sit undisturbed? What is your tax rate on interest, and what would you keep after tax from each option? Have you read the account agreement or the bond's official statement, including how the rate can change and what happens at the end date? And last, are you choosing the tool that fits your date, or the one with the shiniest number?