Pros and Cons of CDs
Certificates of deposit, also known as CDs, can be thought of as agreements made between banks or credit unions and their customers. Customers place a sum of money with the bank for an agreed upon period of time, typically between 3 months and 5 years. During that time the bank offers the customer a premium interest rate (usually a fixed rate) in exchange for locking in that money.
Once the time period that has been agreed upon between the bank and the customer ends, then the bank returns the money to the customer in addition to whatever interest they owe.
If you are looking to safekeep your money in certificates of deposit, then you should learn both the positives and negatives that accompany them. This article will detail the main pros and cons that accompany CDs.
Pros of CDs
Higher Returns than Savings Accounts
Savings accounts are a great way to keep your money safe and secure, and savings accounts also pay you interest on the money that is in your savings account. Banks offer savings accounts because their customers are likely to keep a decent sum of money in their account, which the bank has available to them to go out and make loans and investments. However, you can withdraw money from your savings account at any time with no penalty, which sometimes can leave the bank in the lurch since they are required to match money coming in (deposits) with the money going out (loans).
Banks developed CDs to help them better match their sources and uses of funds.
When you purchase a certificate of deposit, you are not able to withdraw your money before the agreed upon maturity of the CD without incurring a penalty. While the money is always available to the customer, the penalty effectively discourages the customer from accessing those funds earlier than the agreed upon time. In exchange for the lack of liquidity, banks typically offer a higher interest rate for certificates of deposits. The longer the maturity of the CD, the higher the rate.
If you currently have money in a savings account and you know with certainty that you will not need it for the next six months or longer, then you should ask your financial institution about a certificate of deposit. Your money will be just as safe as it is in a savings account, and you may receive more interest from a certificate of deposit than you would from your existing savings account.
Another benefit of certificates of deposit is that they offer fixed returns. This means that the interest you receive at the end of the term will not reflect the changes of the economy during that time.
So, if the federal reserve were to decide that the federal funds rate was to be lowered, then the rates of all successive CDs would be lowered as well. However, since you locked in the rate on your certificate of deposit before the federal reserve lowered the federal funds rate, your rate will not change.
This can be very helpful in helping you plan your finances. Knowing that your account will grow at a guaranteed rate can make it much easier to plan your finances in the present as well as the future.
The flip side to this is that your account would not reflect increases in interest rates either. If interest rates are at all times low, you may want to consider a high yield savings account, but if interest rates are already very high, then a CD could be a great way to lock in that rate.
Little to No Risk
This benefit has also been mentioned in the other pros that accompany CDs. As long as the account is FDIC-insured, a certificate of deposit carries very little risk because it is insured by the federal government. The U.S. government is one of the safest institutions to invest in that exists!
Make sure you ask your financial institution how much of your account balance is federally insured. FDIC insurance is typically offered for balances up to $250,000 per account, but financial institutions are getting increasingly creative to increase the insured balances for the convenience of their higher net worth customers.
A typical certificate of deposit is not very flexible because it is set at a fixed rate, and you are not able to withdraw from it. However, there are a few examples of certificates of deposit that have been developed to increase flexibility. Examples of these types of CDs are:
Liquid CDs are certificates of deposits that offer you the ability to withdraw your money at any time with no penalty. However, this type of certificate deposit has lower interest rates than other CDs, probably very close to a typical rate on a savings account. This type of certificate of deposit sacrifices your investment yield for a more liquid asset. Make sure you ask your financial institution about the fine print to ensure there aren’t any unknown restrictions on accessing your money.
A step-up certificate of deposit is a CD that increases the interest rate associated with the CD after certain periods of time. This can help investors partially protect against inflation risk due to the higher returns that they would be getting from higher interest rates.
IRA CDs are certificates of deposit that are linked to a retirement account. They follow most of the same rules as a typical retirement account so it’s good to be aware of all those restrictions. The primary benefit of this type of account are the tax benefits. For a Traditional IRA CD and SEP IRA CD, you'll typically contribute money before taxes are taken out, then pay income tax on withdrawals. For a Roth IRA CD, you'll contribute after-tax dollars but won't pay taxes when you withdraw the money. IRA CDs are a better option for people nearing retirement, because of the low risk of the financial instrument. As we know, low risk usually means low return, and an IRA CD is no exception to that rule.
Cons of CDs
Liquidity risk is one of the biggest negatives when it comes to certificates of deposit. While liquidity in a CD is typically better than lots of other types of investments, you are still unable to withdraw your money once you have purchased the certificate of deposit without paying a penalty.
Liquidity is the ability to readily turn assets to cash. Once you purchase a certificate of deposit it is considered an asset. However, you must wait until the end of the contract term to receive the cash value.
If you are looking to invest in something that is extremely liquid because you are uncertain of your near-term financial status, then you may want to steer clear of CDs or keep their maturities less than 1 year.
Inflation risk is the idea that increased inflation will diminish the returns that you receive from an investment. Another way to think about inflation risk is to think of it as purchasing power. As inflation increases, the costs of the same pool of goods go up, and the purchasing power of your dollar goes down. Certificates of deposit can be subject to inflation risk.
Some level of inflation is very normal. Typically inflation in the US might range between 0 and 2% per year.
With higher levels of inflation, the return you would receive from a certificate of deposit will not be as attractive. As we’ve learned, the returns of a certificate of deposit are fixed. While fixed returns can be a good thing in some circumstances, a CD can be a poor investment during times with high rates of inflation.
Like all other profitable investments, certificates of deposit come with tax liabilities. The money that you accrue in interest is subject to tax. The tax that you must pay on the interest that you accrue can take away from the money that you make from the investment.
As you can see, there are various pros and cons that accompany CDs. You may want to look into CDs depending on what your investment goals are. If you are looking to find a very safe option to hold your money that will net higher returns than a savings account, then CDs may be a good alternative. However, if you are looking to make larger returns on your money or have the flexibility to withdraw your money at a moment’s notice, then you may not want to invest in CDs.
High yield online savings accounts can sometimes provide returns nearly just as high as some CDs without any of the restrictions, which might allow you the flexibility to take advantage of the next investment opportunity when you come across it.