A Certificate of Deposit is not the most popular investment option that you will find in most circles. It has a reputation for being boring and predictable with its outcomes. Despite this stodgy nature, that is precisely the reason why it can be a compelling option when you want to grow your wealth in conservative ways.
The Certificate of Deposit is one of the safest investments that are available right now. If you want to park your money for a period of up to five years, then you can earn significantly more than what would be available from a savings or money market account.
CDs are currently earning a lower interest rate when compared to the higher APY options that were available in past cycles. What you can enjoy with this investment option is the peace of mind that comes when you know that your money is safe. If the market is uncertain, then this option provides a level of surety that other choices can’t always offer.
As with every other form of securities or investments, a Certificate of Deposit has several advantages and disadvantages that you will want to consider before finalizing your investment. These are the critical points to review before putting your money into CDs.
List of the Advantages of a Certificate of Deposit
1. CDs are so safe that no one has ever lost money in them.
The Certificate of Deposit receives protection with federal insurance when you have this investment product in an approved bank or credit union. It receives the full faith and credit of the United States government. That means you have $250,000 of protection available immediately for this investment. It is one of the most significant benefits to CD investors.
According to the FDIC, no one has ever lost a single penny when investing in insured certificates. The funds that get deposited at a credit union receive similar backing from the National Credit Union Association. The only way that you can lose money from this investment is to withdraw it early.
2. It offers a better return than a savings deposit.
Although a Certificate of Deposit doesn’t earn a significant return, what you receive is higher than what a savings account provides. This advantage occurs because you don’t have the option to take your money back at a moment’s notice. That means a CD is more valuable to the bank then a personal account. You receive a higher yield in exchange for locking your money into this option for a set time.
Most consumers invest in a Certificate of Deposit with the same bank or credit union where their checking and savings accounts are held. You do have the option to shop around to see if someone can give you a better rate.
3. You have a wide selection of terms from which to choose.
A Certificate of Deposit comes with an assortment of yields and maturities from thousands of different banks and credit unions. You can even invest in this product online with some providers. The terms that you will find available can range from three months to an entire decade. By providing you with this diverse set of choices, it becomes much easier to find a CD that fits your specific needs.
4. The returns from a CD are fixed and predictable.
When you save money in a Certificate of Deposit, then you receive an advantage that isn’t possible with other deposit account formats. The interest rate that you receive upon opening the CD stays the same, even if the rates fall in the broader economy while this investment product is active. Your investment receives a guaranteed return based on the terms and conditions you agreed to follow.
5. You will receive bigger returns for long-term CD investments.
As of January 2020, the best rates for a Certificate of Deposit are at 2.15% for a 12-month CD. You can find six-month options available at 1.9%. When you start looking at rates of 6-10 years, then you’ll find offers that range from 2.3% to over 3% from some providers. When you can commit to a long-term investment with CDs, then you will experience a higher interest rate offer for the money you commit to that account.
6. CDs are a convenient investment option for the average household.
One of the best advantages associated with Certificate of Deposits is the fact that you can open one at almost any bank or credit union. There are several types available from which to choose so that a variety of savings goals can be met. It is highly likely that you can find something that works for your specific situation from a local provider. Online banks often offer higher rates than a local branch, but the penalties for early withdrawal can also be significantly different.
As long as you are aware of the trade-offs that are sometimes necessary with CDs, you can put your finances into a safe position where some growth as possible.
7. Some Certificate of Deposit options allow you to change the interest rate.
Having a fixed rate offered by a CD can be a benefit, but it can also become a disadvantage if you get stuck with a lower rate when interest percentages rise. Some institutions counter that problem by offering what is called a bump-up Certificate of Deposit.
If you have this advantage available with your CD, then you will have the option to increase your rate at some time over the course of the Certificate of Deposit term. You might only get one adjustment, so choosing when to make the change is a critical component of your eventual success.
8. Jumbo CDs are available through some institutions.
Several banks and some credit unions offer an investment product that’s called a jumbo CD. This Certificate of Deposit often has a minimum deposit amount of $10,000, and some of them require at least $100,000 to get started. This advantage allows you to earn a significant interest rate if you can park that much money for a long time. Many investors consider this option before opening an annuity or pursuing a savings option through universal life insurance because the return is better.
9. You can open CDs without having a lot of money.
Even if you only have $100 that you can invest right now, most banks and credit unions have a Certificate of Deposit available for you to use. The most common minimum amount is $500, but some institutions allow you to deposit anything into this account. You will only earn a few dollars with these small CDs, but it can be an excellent way to begin thinking about how to invest in the future.
You’ll also earn more money in interest by placing small amounts into CDs than you would by storing it in a savings account.
10. Some banks and credit unions provide a step-up CD option.
If you have access to a step-up CD, then this Certificate of Deposit gives you the option to take a small increase in your interest rate during specific intervals. This option typically occurs twice per year. If the APY goes up during that time, then you can add a small increase to your overall returns. When interest rates stay the same or go lower, then you still have the option to maintain the current APY.
11. Some CDs are available without an early withdrawal penalty.
Investors that have concerns about liquidity can still take advantage of the benefits that a Certificate of Deposit provides by pursuing a no-penalty CD. Some of these products are labeled as being a “no fee” CD. You won’t receive an interest rate as high on this CD as you would one that locks in the money over a specific term, but you’ll have more access to your cash if an emergency arises. The rates on this option are generally slightly better than if you were to open a money market account.
12. Tax-advantaged retirement plans allow you to include CDs.
Your tax-advantaged individual retirement accounts allow you to include a Certificate of Deposit as a way to protect your money. Roth IRAs and their traditional counterparts both offer this solution. Whether you pay someone to manage your balances or do all of the work yourself doesn’t matter. There can be different rules that apply for your taxes in this situation, so it is usually wise to consult with a financial advisor first before exploring the individualized benefits that might apply with this benefit.
13. Most Certificate of Deposit accounts pay interest monthly.
Although some CDs only allow you to collect interest when the investment product reaches its maturity date, most banks and credit unions will put money in at least once per year. Some of them do it monthly or quarterly. When your balance increases in the account, then the amount you receive in interest will also rise. Compounding this figure into bigger profits over time helps your wealth to grow. It might not be as fast as dividend payments from stock investments, but it is more of a guaranteed approach to consider.
14. Most CDs have no fees or low costs to open the account.
A Certificate of Deposit is an investment option that has no fees associated with it at most banks and credit unions. Many institutions don’t even charge a monthly fee to hold your money in this account. That means you don’t need to worry about any costs impacting your overall earnings.
You must read the fine print in the CD agreement to ensure that you can take advantage of this benefit. If you’re not sure about fees or penalties, then ask questions before depositing your money. That way, you’ll have a chance to avoid issues that could negatively impact your principal or the interest you want to earn.
List of the Disadvantages of a Certificate of Deposit
1. CDs offer limited liquidity for what can be a significant time.
The primary disadvantage of using a Certificate of Deposit is that your money gets locked away for a potentially long time. If an unanticipated need arises, then you typically need to pay a penalty for early withdrawal. This cost can come in the form of sacrificed interest or a loss of principal in some situations.
This disadvantage is the reason why investors who like CDs will create a ladder with multiple rungs. By creating a series of different maturity dates, more liquidity becomes available for your personal finances. You can build one immediately by purchasing a six-month, 12-month, and 2-year Certificate of Deposits to begin producing returns.
2. Significant inflation risks exist for CDs.
A Certificate of Deposit often lags behind the rate of rising inflation, and the interest rates drop faster than the economy experiences when deflation occurs. That means investors who use this option to park their money have a significant risk of a loss of purchasing power over time. It is not unusual for the gains in a CD to be less than what inflation is over the time it is active.
Even if you receive a 5% total return over ten years, you could lose a significant amount of purchasing power if inflation rises at 3% per year.
3. The returns on a Certificate of Deposit are relatively low.
Although the yields that get tied to CDs are usually more favorable than what you will find with money market accounts, or your typical checking and savings, the returns are much lower than what they are for other asset classes. Most investors can achieve better results by investing in stocks or bonds.
Because a Certificate of Deposit is such a safe investment, the returns are generally quite low. There are times in the past with a 5-year CD provided investors with a 12% return, but that happened all the way back in the 1980s. Now the average 5-year CD struggles to provide an annual yield of 3%.
4. CDs provide people with a re-investment risk.
When interest rates start to trend downward, then investors who lock in a specific rate will face the predicament of needing to invest in a lower-yield CD when their current Certificate of Deposit matures. This issue is called a “re-investment risk.” If the interest rates are rising, then this disadvantage disappears entirely.
With rates as low as they are today, it doesn’t make much sense to lock in a long-term CD right now. That’s why the creation of a Certificate of Deposit ladder with varying maturities on short-term investments makes more sense. You’ll have more opportunities to take advantage of higher interest rates in the future.
5. You must look at the early withdrawal penalties very carefully.
Most early withdrawals on a Certificate of Deposit involve a penalty that is a specific amount of interest. The final figure is typically based on the term length of your account. If you opened a three-month CD, then the early withdrawal penalty might be one month of interest. If you have a Certificate of Deposit of two years or more, then your penalty could be up to 12 months of interest.
The issue with this disadvantage is that many banks and credit unions have a minimum penalty amount that you must pay. If that figure is more than the amount of interest that you would earn, then you will lose some of your initial investment plus all of the interest on the account.
6. You must pay taxes on the interest you receive from a CD.
When you earn interest from a Certificate of Deposit, then the government typically taxes the amount that you gained when non-qualified money was used to open the account. This disadvantage applies to retirement accounts that aren’t funded by post-tax wages. When taking a disbursement or transitioning the money into a new account after maturity, then you’re responsible for the profits made from the interest.
If you funnel money into an IRA before taxes with a corporate match benefit, then you’d need to pay the current tax rate for the CD’s principal and the interest you earned. That’s why a Roth IRA is an advantage for retirement planning if your income levels qualify for this unique account.
Banks and credit unions use the funds from issuing Certificate of Deposit to spend, land, or hold in reserve money for their operations. They also have several other choices, which is why the availability of alternatives ultimately determines the interest rates that get paid on CDs.
CD rates are lower than the prime rate because profits are necessary in the financial services industry. Their revenues come from the interest paid by borrowers. That means their costs are the interest paid to lenders, such as the depositors who have cash in a Certificate of Deposit.
You have less access to your money than even what is available with a money market deposit account, so that promotes a stronger return. It also locks your money away for a pre-determined time, creating problems with access if an emergency arises. That’s why the advantages and disadvantages of a Certificate of Deposit must be treated the same way as any other investment choice.
Blog Post Author Credentials
Natalie Regoli, Esq. is the author of this post and the editor-in-chief of our blog. She received her B.A. in Economics from the University of Washington and her Masters in Law from The University of Texas School of Law. In addition to being a seasoned writer, Natalie has almost two decades of experience as a lawyer and banker. If you would like to contact Natalie, then go here to send her a message.