Are CDs a Good Investment? (Pros and Cons of Investing in CDs)
Even the simplest money management strategy should include diversification. No one should have all their wealth tied up in one type of asset, where a financial disaster affecting that asset could do major damage. Money management should involve choosing ways to save and invest that balance out your personal tolerance for risk and reward. One investment you probably haven’t heard about much in recent years is the certificate of deposit, or CD.
In basic terms, a certificate of deposit is a savings account with a fixed interest rate and a fixed term of months or years. CDs work similar to a savings account, but often earn more interest. Over time, as your CD matures, it makes money in interest. Once the term is complete, you can cash in your CD and get the original amount you invested, plus the interest you earned over the course of the term.
Below, we’ll cover the ins and outs of investing in CDs, the pros and cons of CDs, and whether certificates of deposit are worth it. You can read end-to-end for a fuller understanding of investing money in CDs, or you can use the list below to jump to a section of your choosing.
- What Are CDs?
- Certificate of Deposit Benefits and Risks
- Mistakes to Avoid When Buying CDs
- Are You a Good Candidate for Investing in CDs?
- Do Consider Investing in CDs If…
What Are CDs?
A certificate of deposit (CD) is a type of savings account that holds a pre-set amount of money for a fixed time period, typically six months, one year, or five years. The issuing bank pays interest over the term of the CD. When the term is up, you cash in your CD and receive your original investment plus interest. If you buy your CD through a federally insured bank, your CD and other accounts in that bank are insured up to $250,000 in total. (In other words, the $250,000 insurance is on a “per depositor” rather than a “per account” basis.)
Certificate of Deposit Benefits and Risks
As with most things in life, a certificate of deposit comes with its own set of risks and benefits. If you’re considering opening a certificate of deposit with a bank or other financial institution, it’s important to weigh the benefits and risks of certificates of deposit to ensure they’re right for your current financial situation. Take a look at the pros and cons of CDs below.
Benefits of CDs
A certificate of deposit can be a great way to secure and grow your money over time. With that said, there are many benefits you may want to consider as you explore CDs. Some of the advantages of CDs include:
- Produce better returns than saving accounts: The biggest benefit of CDs is that you can earn higher yields than you would with a traditional savings account. This is because unlike savings accounts, money placed in a CD is traditionally locked in for a fixed term (there are some unlocked/no penalty CDs), which is more valuable to a bank. This prompts banks to offer higher rates than a traditional savings account. However, due to the coronavirus pandemic, the Federal Reserve is holding rates close to zero, which could make placing money in a CD less appealing at the moment.
- Safe and secure: CDs can be a very secure savings option if they come from a federally insured bank or financial institution. This is because the FDIC insures CDs up to $250,000, which means your money will be protected even in the event of a market crash or bear market. Though there is always the risk that a bank could default or have a run on funds and that you might not have access to your cash right away.
- Numerous term options: If you’re looking for a short-term investment, CDs are a viable option. This is because CDs come with different maturity dates, such as six months, one year, and five years, making it easy to align your funds with your financial goals. You can even find CDs with terms as short as a week or as long as ten years, making them a flexible and attractive savings option for many.
- Predictability: You can predict your CD’s growth, as they have a locked-in interest rate. Unlike stocks where you can gain or lose large sums of money over the course of one day, CDs have a clear trajectory. The fixed, predictable terms that CDs offer can give you peace of mind knowing you have a guaranteed rate of return, even if interest rates fall in the general economy.
- Potential for no fees: Some banks might not charge you a fee to hold your money in a CD. This means you won’t have to worry about hefty monthly fees digging into your CD earnings.
Risks of CDs
CDs are simple and safe, but they don’t get a lot of press. While there are many attractive advantages of CDs, there are a few disadvantages you should be aware of, too. Take a look at some reasons why you may stay away from placing your funds in a CD.
- Early withdrawal fees: Withdrawing money before your CD matures can result in you paying an early withdrawal penalty or having to forfeit a portion of the interest you earned. The cost of an early withdrawal fee varies depending on the bank and the length of your CD. For example, Marcus by Goldman Sachs charges 90 days of interest for CDs with a term of fewer than 12 months, 270 days of interest for CDs with terms between 12 months and 5 years, and 365 days of interest for CDs with terms more than 5 years.
- Limited access: Certificates of deposit have limited liquidity, which means you don’t have access to your CD until it fully matures. This can pose a problem if you need money for an emergency or other expense because you won’t be able to withdraw funds without paying an early withdrawal fee or penalty that taps into your earned interest or principal.
- Yields lower returns: While CDs offer higher yields compared to traditional savings accounts, they’re relatively low compared to other investment options, such as stocks and ETFs. However, stocks and ETFs are volatile and risky, as they can lead to significant losses with market fluctuations.
- Inflation risk: People shy away from CDs when they expect interest rates to go up. Who wants to lock a bunch of money away for five years at 2% when interest rates can potentially rise to 3%? When interest rates are low, rates on CDs don’t look that great. They may be only a little higher than what’s offered on regular savings accounts.
- Taxes: Whenever you produce a gain, the government is going to want their fair share. CDs allow you to grow your money in the form of interest over time. When it’s time to cash in your CD once the term is up, you’ll take home your principal balance and any earned interest. This earned interest will be taxed by the government, which is why it’s important to plan ahead.
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Mistakes to Avoid When Buying CDs
As you shop around for a certificate of deposit, it’s important to know common mistakes people in your situation might make. Some mistakes to avoid when buying CDs include:
- Failing to research the best CD rates: The market is filled with CDs offered by banking and financial institutions that all offer their own rates. To get the most bang for your buck, you want to do your research, including looking outside of your primary bank, to ensure you choose a CD with the best rate.
- Placing all of your money into a CD: When it comes to finances, it’s often recommended not to put all of your eggs in one basket. This is because you don’t want to find yourself stranded with limited access to money in the event of an emergency. When it comes to CDs, you might want to consider placing your money in multiple CDs with different maturation dates, such as six months, one year, and five years, as well as diversifying your money across other security type depending on how much money you have to invest, the time until you will need the money and your goal for investing it.This can give you more wiggle room when it comes to withdrawing money for emergencies or reinvesting.
- Withdrawing from your CD early: As stated, you can face a hefty fee if you withdraw from your CD prior to its expiration. When you open a CD, you make an agreement with the bank that you’ll keep your money there for a designated period of time. During this time the bank uses your money to fund the needs of other bank customers, so, when you take the money early, the bank needs to find new cash and that is why they must charge a fee. To ensure you’re not strapped for cash, you might think about placing your money in multiple CDs, and consider creating an emergency fund that you can easily access.
- Picking the wrong investment type for your goal: There are numerous investment and savings vehicles you can take advantage of to grow your wealth, with CDs being one of them. If you can’t commit to a fixed-term, you might want to consider exploring different options, such as high-yield savings, money market accounts, stocks, bonds, and so forth.
- Not keeping tabs on the federal interest rates: The Federal Reserve controls interest rates, which can impact the rates on your CD. For example, in a slow economy, the government will slash interest rates to encourage spending. If the economy is growing too fast, the government will raise interest rates.
Do Consider Investing in CDs If …
Are certificates of deposit worth it? That answer depends on a variety of factors and your current financial situation. Weighing the certificate of deposit advantages and disadvantages can be a great way to narrow down your decision. Generally, CDs make better investment vehicles if certain conditions are satisfied that allow you to get the most from them. Specifically, CDs may be worth exploring if:
- You already have a healthy emergency fund. You shouldn’t invest your emergency fund in a CD because of the early withdrawal penalties of CDs. Emergency funds should be in an account that you can access without penalties in an emergency.
- You want a stable portfolio. Maybe you have some riskier investments and wish to counterbalance them with stability. CDs could be good for this.
- You’re not worried about inflation. If inflation is higher than the interest rate you’re getting on your CD, you could be kicking yourself over your lost purchasing power. But if you’re confident inflation will remain low, CDs can be useful money management tools.
Whatever your money management style, you’ll find Mint to be indispensable for tracking your bills, expenses, and investments. You can monitor all of your investments in one place, and with the Mint mobile app, you can do so wherever you go.
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