Advantages and Disadvantages of a Certificate of Deposit
A certificate of deposit, or CD, is an investment option that is considered low-risk. However, consumers looking for a higher rate of return or liquid investment may want to consider other options such as mutual funds.
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There are a variety of ways for consumers to invest their hard-earned cash in different financial products. Some methods, like the stock market, can be risky, while others, like a certificate of deposit, are less so.
Commonly referred to as a CD, a certificate of deposit is a promissory note that is issued by a bank or credit union and insured by the FDIC (Federal Deposit Insurance Corporation.) They come with a fixed interest rate and maturity date.
Along with being FDIC-insured, CDs are typically available for as little as a few hundred dollars or as much as $250,000, with terms as short as a couple weeks or as long as 10 years, though the most popular terms tend to be between two and five years.
Once you purchase a CD, you can’t access the funds until the maturity date, which is when the entire term ends. Once matured, the owner of the CD can withdraw the funds plus any interest accrued. If you need to withdraw your funds early, you’ll likely have to pay an early withdrawal penalty. CDs are similar in many ways to a money market account.
On this page:
- Certificate of Deposit Advantages
- Certificate of Deposit Disadvantages
- What to Consider Before Investing in a Certificate of Deposit
Certificate of Deposit Advantages
There are numerous advantages to investing in a CD, many of which make them an attractive option for consumers looking for a low-risk investment that doesn’t require a significant amount of money up front.
One of the most appealing aspects of a CD is that it’s a relatively safe investment. Even if the market changes, the matured CD will maintain the value expected at purchase. However, if the funds are drawn before the maturity date, a fee will be applied.
Holding a CD also brings income predictability. At the time of purchase, an investor knows exactly how much the CD will be worth at the close of the term. Unlike the stock market, there are no market-based surprises, and the interest accrued will not increase or decrease as long as the CD is left to mature.
Flexibility of Terms
With both short-term and long-term CD options, investors can choose a strategy that works best for their financial situation. Granted, a short-term CD won’t yield as much as a long-term CD, but it will likely yield more than if it was stored in a high-interest savings account.
Additionally, investors have a variety of CDs to choose from:
- Liquid CDs, which have a no- or low-penalty withdraw features
- Step-up CDs, which have rates that increase at intervals
- IRA CDs, which are CDs placed in an individual retirements account (IRA)
- Bump-up CDs, which allow investors to capitalize on new higher interest rates throughout the term of the CD
In addition to flexible terms, investors also can use the CD ladder approach to capitalize on accrued interest over time. A ladder CD is a group of CDs with varying term lengths. As each CD matures, the money, with interest, is reinvested into a five-year CD, creating a reoccurring investment.
Returns are Better than a Savings Account
For the most part, a savings account will yield around 2.0% to 2.15% in interest. On the other hand, some of the best CD rates can be anywhere from 2.71% to 3.51%. Additionally, a savings account does not come with tiered interest rates, while the interest rate applied to a CD typically increases with a longer term.
Certificate of Deposit Disadvantages
Though CDs often represent a safe and predictable way to invest money, they may not be right for everyone, particularly investors who may need to access the cash before the term expires or who are seeking a higher return on investment.
CDs are designed to entice investors to keep their money in the CD until the end of the term. As such, early withdrawal before maturity will typically result in a penalty. Since you can’t simply withdraw funds like you could with a savings account, this type of asset isn’t considered to be liquid in the way a savings or checking account would be.
Typically, the rate of inflation is not congruent with CDs, and in some cases, the rate of inflation may grow faster than the interest on a CD. Though this may not always be a concern, it’s one that should be taken into consideration, particularly for long-term CDs.
Though CD interest rates are typically higher than those associated with savings accounts, they can pale in comparison to more aggressive and higher-risk investments like stocks and bonds. For example, a five-year, $500 CD with a top interest rate of 3.50% will only yield about $95.62 in interest by the time it matures.
What to Consider Before Investing in a Certificate of Deposit
If you have some extra cash that you’d like to invest, and you won’t need to tap into it immediately, a CD can prove to be a valuable investment when compared to other types of savings accounts. Since CDs are backed by the FIDC, they are a safe and predictable way to increase your wealth without taking on the risk often associated with other types of investments like stocks.
However, keep in mind that CDs lack liquidity, and withdrawing early will likely cost you. Additionally, if you’re looking for a higher rate of return and are comfortable with an increased risk, then a CD may not be your best option.
Author: Jennifer Lobb