A certificate of deposit (CD) is a federally-insured savings account which offers a fixed interest rate and a fixed date for withdrawal. It acts like a traditional savings account that you would have with your checking at a bank or credit union with the exception that it comes with a maturity date. This product does not have monthly fees, although you will pay a penalty if you must access the cash early.
Most people look at a certificate of deposit as an easy way to earn some interest on their cash in a way that is safe and guaranteed. When the regular savings interest rate hovers between 0.5% to 1% with most financial institutions, you can see 3-year CDs offering a 2.75% to 2.9% interest rate instead. That means you have the option to triple your earnings from your current cash investments with almost no chance at a loss.
Credit unions typically offer a certificate of deposit as a share certificate. Both products are insured up to the same amount that you deposited, just as the amounts are in your regular savings account. There are specialty CDs and ladders you can create to help you generate a return on your cash as well.
Here are the pros and cons of a certificate of deposit to consider if you are looking for a way to diversify your portfolio.
List of the Pros of a Certificate of Deposit
1. CDs are one of the safest methods of creating a positive cash flow.
According to information provided by the FDIC (Federal Deposit Insurance Corporation), no one has ever lost money when investing money into a certificate of deposit that was federally insured. The same holds true for those who use a credit union for their banking needs because the NCUA (National Credit Union Association) insures those amounts as well. You receive the full faith and credit of the U.S. government for up to $250,000. That means your money can grow without you worrying about losing it.
2. It offers a better return than most savings accounts.
Because you are unable to take out your money at a moment’s notice with a certificate of deposit, account holders have access to a higher interest rate because the account is more valuable to the bank or credit union. Although the interest rates are usually around 3% for a 5-year CD (which means a $5,000 investment would yield $880), that is still better than the $500 you would receive from a 1.9% standard savings account at the time.
Although that amount seems negligible at first, imagine if you have $50,000 to invest that you don’t want to risk on the stock market or in mutual funds. You’d earn $3,800 more during that time.
3. You have access to a wide variety of terms with CDs.
Most certificate of deposit options offer account holders a 1-year, 3-year, or 5-year account to take advantage of specific interest rates. You will discover that there are CDs with a variety of different yields and maturities from which to choose when you start shopping around for the best options. You can find products that offer three-month holding windows to certificates that require 10 years to reach maturity. That makes it possible to find the exact product which fits your financial needs today.
4. CDs offer investors a return that is fixed and predictable.
When you decide to put your money into a certificate of deposit, then you can count on the CD to provide a specific yield on an agreed upon date. Even if the interest rates fall in the economy after you open this account, the rate that you receive for your money remains fixed until you reach the final maturity date. That is why a 5% CD that is offered would be a great rate to lock in today.
At the moment, Mercantil Bank offers one of the best rates on a CD that is available in the United States, giving you a 3.2% APY on a 5-year certificate of deposit, although there is a $10,000 minimum to meet.
5. The rates of a CD are better that other safe investment choices.
Not only does a certificate of deposit offer a better interest rate than most checking and savings accounts, but it also provides a chance at a better return when compared to money market funds or a similar account at your local bank or credit union. If you know for certain that you will not be needing the cash for an extended period, then you can help it to earn more over time than it would if you just plunked it into a traditional account.
6. You have the option to shop around for the best possible rates.
Many account holders choose to open a certificate of deposit at their local bank or credit union because it is convenient. Keeping all of your money in one location allows you to keep an eye on it without much effort. This setup is not mandatory. You can open a CD at almost any insured institution as long as you can meet whatever minimum amount is necessary to start it in the first place. That means you can shop online or throughout your community to see who is making the best offer.
7. There may not be a minimum amount required to open a CD.
If you want to have access to the highest interest rates possible with a certificate of deposit, then you may need to have a minimum of $10,000 to $25,000 available to take advantage of that premium rate. When you only have a little bit that you want to protect and grow, then national institutions like Capital One make it possible to open a CD with $250 or less. Although you will only see minimal gains with these small amounts, it is a way to begin earning some extra cash that you could reinvest one day to create some compound growth.
8. Specialty CD options exist to counter the potential disadvantages.
There are four specific types of specialty CDs that can help you to counter most of the potential disadvantages that are possible when opening this type of account. If you choose one of these options (if it is available from your bank), then you could maximize your growth potential.
• Bump-up CDs allow you to request a higher interest rate if your bank increases the APYs. This option usually has a lower rate than one that offers fixed-rate terms and faces higher minimums, but it can also let you improve your standing on a long-term investment.
• Step-up CDs offer predictable rate increases when your APY goes up at regular intervals. These usually happen twice per year, which means you can see a small boost in gains every 6 months or so.
• No Penalty CDs are an option to consider if you are concerned about your liquidity. You’ll receive a lower rate of return and must maintain a balance in the account, but you will also receive more access to your cash.
• Jumbo CDs are an option to consider when you have a lot of cash to protect. Most have a minimum balance requirement of $100,000. They do not generally offer a better APY than their counterparts.
9. You can include a certificate of deposit in an IRA.
You can include an IRA CD with your tax-advantage individual retirement account as a way to protect some of the wealth that you have contributed for your future. Traditional and Roth IRAs both offer this option, whether you self-manage the account or have someone do it for you. The taxation rules are a little different when your CD is part of your retirement account, so there may be a need to speak with a financial advisor if you plan to contribute a significant amount to one.
10. You can usually choose to receive your interest payments throughout the life of the CD.
There are some certificate of deposit options that only allow you to collect interest on the account when it reaches maturity. Many banks allow you to receive these payments more often, sometimes even once per month. You can then choose to reinvest that amount in the CD to help it build even more returns over the lifetime of the account or move it into a different account without receiving a penalty.
11. There are ladder options to build with CDs.
When you have a CD ladder, then you have an investing strategy which has you investing in certificates of different lengths. That makes it possible to tap into your money along the way as you need it while keeping the rest invested for a longer time. Even if you have an economic hardship, the amount that you have locked in can still be accessed for what is usually a minimal loss.
List of the Cons of a Certificate of Deposit
1. You remove your liquidity when you invest in CDs.
One of the most significant disadvantages of using a certificate of deposit to grow wealth is that you cannot access your cash easily if an emergency situation or economic hardship occurs. Most account holders must pay a penalty or fee for an early withdrawal. That usually creates a loss of interest, although it can even cause a loss or principal in some instances. This outcome is why investors tend to build CD ladders as a way to have income available and some liquidity as well. If you think you’ll need access to the cash, then a high-yield savings account is the better option.
2. CDs do not always beat the inflation rate.
When you look at a certificate of deposit as an option, then you must also consider the rate of inflation that occurs at the same time. Most CDs tend to lag behind what the inflation rate happens to be, while dropping faster than inflation when it begins to come down. This process creates the danger that the money you put into this account may lose some of its purchasing power by the time you are able to take it out. There is no way to beat this disadvantage unless you create short-term CD ladders that offer yields that match or exceed inflation for that period.
3. Your return on a certificate of deposit is usually rather low.
If you are thinking about a certificate of deposit, then what you are essentially doing is creating an account where you want to maintain the value of what you’ve earned already. The returns for this product are relatively low compared to stocks, bonds, or mutual funds. It may be a low-risk investment in the fact that no one has ever lost money when using an insured account, but that means CDs are also going to offer a minimal return. You will not typically build enough wealth even through ladders to fund a retirement with this option. The only exception was when CDs in the mid-1980s offered 12% interest rates. Most have trended downward since then.
4. There are re-investment risks to consider with CDs.
If you have interest rates trending downward and your CD is about to mature, then you are forced into a situation where you would need to invest in a lower-yield certificate of deposit in the future. When rates are rising, then this disadvantage disappears. That is why it doesn’t usually make sense to lock-in a long-term CD unless the interest rate you receive is five percentage points or higher than the standard rate at that moment.
5. You are taxed on the interest that you receive on a certificate of deposit.
When you earn interest on a certificate of deposit, then you are taxed on the amount that you gain when the CD contains non-qualified money. If you decide to invest this money using a traditional IRA, then the taxes would not become an issue until you needed to withdraw the money as a disbursement. Roth IRA CDs require that you pay the taxes upfront. You will not pay additional taxes on the money that you used to invest in the first place since it already went through the income tax process.
The pros and cons of a certificate of deposit offer account holders a chance to protect their cash while creating some minimal income that they can use to grow their wealth. Although there are other investment products that can offer a significantly higher return, there is virtually zero risk of losing money with this option. It is essential that you weigh each key point carefully to determine if this savings option is the right way to manage your funds.
Blog Post Author Credentials
Louise Gaille is the author of this post. She received her B.A. in Economics from the University of Washington. In addition to being a seasoned writer, Louise has almost a decade of experience in Banking and Finance. If you have any suggestions on how to make this post better, then go here to contact our team.