What is a Certificate of Deposit?
A Certificate of Deposit (CD) is a type of deposit account that offers a fixed interest rate. In exchange for a higher rate, you agree to keep your deposited funds for a specified period of time. CDs provide a low-risk way to earn interest on money you don’t need right now, but they aren’t suitable for every situation. Understanding the benefits and drawbacks can help you assess whether a CD is right for you.
5 Benefits of Certificates of Deposit
Certificates of Deposit offer several attractive features that make them a good option for earning interest on extra funds.
- Fixed Rates and Terms: Investing in a Certificate of Deposit provides a predictable return over a specified time period. When you purchase a CD with a fixed rate, for example, your rate and term are locked in, providing you with consistent growth until maturity. Market rates may change, but your CD rate is secure.
- Higher Returns: CDs often offer higher returns compared to other types of deposit accounts, such as traditional savings accounts, without increasing risk and volatility. Typically, long-term CDs offer higher rates for keeping your funds deposited for a longer period of time.
- Low or No Fees: Although some CDs may require a minimum opening deposit, they typically do not come with additional ongoing fees. Some savings accounts and money market accounts may impose monthly fees that can affect your returns, especially if the annual yield is high enough to provide a noticeable return.
- Safe Investment: When you purchase a CD from a bank or credit union insured by the FDIC or NCUA, your deposits are protected up to a maximum of $250,000. Even if the bank fails, your deposits are guaranteed.
- Diverse Options: CDs come with a variety of options giving you a good selection to choose from. You can select based on how long you want to invest – short-term CDs for 30 days, for example, or long-term CDs for five or ten years. There is also diversity in how interest is earned: fixed-rate CDs, variable-rate CDs, no-penalty or liquid CDs, and brokered CDs.
5 Drawbacks of Certificates of Deposit
The drawbacks of investing in CDs are not prohibitive, but understanding the potential risks can help you make an informed decision.
- Low Rates: You may find that sometimes putting money in a high-yield savings account can outperform locking it in a CD. “High-yield savings accounts are very competitive and often offer better rates for shorter-term periods of less than 12 months,” he says. For periods between three and five years, he suggests exploring options like multi-year fixed annuities, which have some tax advantages. During periods of high inflation, he suggests purchasing I bonds as an option.
- Poor Liquidity: Since you have to commit to a specific time frame, you can’t access the funds deposited in a CD before its maturity without incurring a penalty. If you need to withdraw a CD to cover unexpected expenses, expect to lose a few months’ worth of earned interest. Keeping some money in a more accessible account, like a savings account, provides you with a source for emergency spending, as you are officially allowed six withdrawals per month. However, he says that compared to some types of other investments, the penalty for early withdrawal – if applicable – can be minimal.
- Taxes: Interest earned on a CD is subject to taxes. “You need to claim your interest as taxable income on your tax return in the year it was earned, not just in the year the CD matures,” he says. Depending on your income and deductions, this could lower any tax refund you might have been entitled to receive. Or you may have to pay additional taxes if you paid less than what was owed for the year.
- Risk
Reinvestment: Many certificates of deposit automatically renew unless you notify the bank not to renew your certificate before its maturity. Otherwise, your deposit will usually be reinvested (referred to as “renewal”) at the bank’s current rates, which may cause you to miss out on seeking better rates. You can withdraw the certificate after it has been reinvested if you really need the money, but you will incur an early withdrawal penalty. - Not Building Wealth: The returns on certificates of deposit may not always be high enough to significantly impact your portfolio. Investing in high-yield securities like stocks or index funds can provide greater growth for your money, especially over the long term. Also, you typically cannot add money to most certificates once you secure them, preventing you from earning more interest on a higher balance. Although certificates of deposit have their advantages, they are not a wealth-building tool.
Is Investing in a Certificate of Deposit a Good Option?
Like most financial products, certificates of deposit can be beneficial in certain situations – when CD rates are higher than high-yield savings account rates, for example. I generally look for the point where a CD yields a higher return than high-yield savings accounts, which is typically between one and three years.” Because better rates generally correspond with longer terms, you should be prepared to lock up your money for several months to several years. If you might need the money before that, a certificate of deposit may not be the best option.
If your goal is to build long-term wealth, there are better options than certificates of deposit. The rates are not high enough to significantly increase your net worth.
What is a Ladder of Certificates of Deposit?
A ladder of certificates of deposit is a portfolio composed of CDs with staggered maturity dates and interest rates. By spreading your investment across CDs with different terms, you will not lock all of your money for the same time period.
Why Are Certificates of Deposit Considered a Very Safe Investment?
Most certificates of deposit are insured up to $250,000 when purchased from an FDIC or NCUA insured bank or credit union. This means you won’t lose your investment if the bank fails. Once you purchase the certificate, your rate is locked in and will not decrease even if market rates drop.
Where Can You Get a Certificate of Deposit?
You can obtain a certificate of deposit from banks and credit unions, including online banks, traditional banks, and even small community banks and credit unions. They can also be purchased through a brokerage firm.
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Source: https://www.thebalancemoney.com/certificate-of-deposit-benefits-and-drawbacks-5226054
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