Certificates of Deposit (CDs) can be a valuable part of your investment strategy. They often help you earn more than you would from a traditional savings account while providing predictable returns.
How Investing in a Certificate of Deposit Works
When you invest in a Certificate of Deposit, you deposit a specified amount of money into a savings account for a fixed period of time to earn interest. CD terms typically range from one month to five years, but you can find CDs for 10 years or longer. At the end of the term, you receive your original deposit plus the interest you earned.
5 Common Mistakes in Investing in Certificates of Deposit to Avoid
Although CDs can offer many benefits to investors seeking low-risk assets with predictable returns, they come with some drawbacks worth considering. If you invest in CDs, you’ll want to use them within the framework of your broader financial goals. Here are five mistakes to avoid:
Withdrawing Your Money Early
Investing in a Certificate of Deposit and withdrawing your money before maturity can be costly. CDs are designed to reward you with higher interest rates than savings accounts because you agree to leave your money in them for a specific period. If you withdraw your money early, you’ll typically have to pay an early withdrawal fee. The cost of fees and rules varies from bank to bank, so make sure to compare before choosing a CD.
Opening a Fee-Paying Account First
Some banks and credit unions may require you to open a checking account before you can get a Certificate of Deposit or preferred CD rates from them. This can be an issue if the checking account carries any costs. While the best CD rates exceed 3%, national average return rates range from 0.03% to 0.39% as of May 16, 2022. Overall, the financial return is modest, so the fees associated with checking accounts can eat into your returns.
Using CDs Instead of Better Investments
CDs carry low risk, but they also return low yields. Therefore, it may be a mistake to invest your money in CDs before investing it in other accounts that offer higher or more liquid returns. “In reality, if you have funds earmarked for long-term goals tied to a CD, they don’t compete with the rising costs of goods and services over time, especially if you’re far from retirement,” said Marini Demoriak, CFP, of Demoriak Financial Consulting and Wealth Management, in an email to The Balance.
Opening a Certificate of Deposit When Rates are Rising
Investing your money in a long-term Certificate of Deposit can work against you when interest rates are rising. “The sense of security a CD offers shouldn’t make you feel safe when inflation rates are double or triple what the CD is currently paying in interest,” said Demoriak. “The purchasing power risk is one of the biggest risks your money faces, and this is something people often forget when they are only investing in CDs.” Opening a CD in a rising rate environment means you could be missing out on higher returns, said Ryan Ortega, a financial advisor at Third Line Financial, to The Balance in an email. “By locking your money away for a long time (in a CD), you miss the opportunity for higher returns if rates climb significantly,” he said.
Opening a Certificate of Deposit Instead of Paying Off High-Interest Debt
Finally,
When making decisions about how to invest, don’t forget to take your current debts into consideration along with other investment options. If you have debts that cost you more than a certificate of deposit can earn you, investing in the certificate would be a mistake. For example, assume you have an installment loan of $1000 with an annual interest rate of 12%. This means you’ll pay $120 in interest over the year while repaying the loan. If you have $1000 but decide to invest it in a one-year certificate of deposit with a competitive interest rate of 1%, you’ll only earn $10 over the year. Overall, you would have a net loss of $110. If you instead paid off the $1000 loan, you would save $120 and be in a better position.
Conclusion
Certificates of deposit are considered a low-risk investment and can offer modest and predictable returns you can rely on. Research interest rates before investing, prioritize paying off high-interest debt, and explore other investment options. You may want to avoid investing money for a long time if you might need it soon. Finally, you may want to consider using a “laddering strategy” for certificates of deposit to enhance your liquidity, especially in a rising interest rate environment.
Frequently Asked Questions (FAQs)
When is a certificate of deposit the best option?
Certificates of deposit can be a great way to safely store money for short periods, but low-interest rates often aren’t competitive enough to keep pace with inflation and rising interest rates over the long term. Certificates of deposit are typically insured by the FDIC up to $250,000.
What is the minimum balance for a certificate of deposit?
The minimum balance for a certificate of deposit will vary from one financial institution to another and can differ among certificate offerings within the same institution. Some banks have no minimum balance requirements.
How can you purchase a certificate of deposit?
To purchase a certificate of deposit, you will need to find a bank or credit union that offers certificates of deposit with the rates and terms you are looking for. You will then follow the steps provided by the financial institution to open the account. This usually includes completing an application, agreeing to the terms, and making a deposit.
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Sources:
The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts in our articles. Read our editorial process to learn more about how we fact-check and maintain the accuracy, reliability, and quality of our content.
U.S. Securities and Exchange Commission. “Certificates of Deposit (CDs)”
Federal Deposit Insurance Corporation. “FDIC: National Rates and Rate Limits.”
FDIC. “National Rates and Rate Limits.”
Chase Bank. “Open a Certificate of Deposit Account at Chase.”
Source: https://www.thebalancemoney.com/mistakes-to-avoid-with-a-cd-5223903
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