Investing in a certificate of deposit (CD) account provides you with several benefits, but they may not be what you’re looking for in your unique situation. As with anything in the investing world, you face some risk with CDs, though the risk is considered low. So you have to weigh the CD pros and cons before you decide to open a CD account. To see how this type of investment may work for you, consider working with a financial advisor.
What Is a Certificate of Deposit (CD)?
CDs are safe, low-risk savings vehicles that banks and credit unions offer. Like a bond, a CD collects interest and has a date of maturity or term length. The time span can stretch anywhere from just seven days to 12 years. The bank or credit union will return your deposit plus interest at the end of that term. But if you withdraw your money early, you will face a stiff penalty.
To calculate how much interest you could earn with a CD, try using SmartAsset’s CD calculator.
Ultimately, the amount of your return depends on the bank and the Annual Percentage Yield (APY) it is willing to deliver. But these days, you can compare CD rates from banks across the country online to find the right institution or account for you.
And when exploring CD options, you should also pay close attention to how the bank compounds interest. Given the same interest rate and term length, a CD that compounds interest on a daily basis will pay out more than one that does it on a quarterly basis. Financial institutions also tend to offer higher APYs on long-term CDs.
Nonetheless, there are many advantages to CD investing and even different strategies you can take with your investment that may help your situation. However, it’s important to weigh the pros and cons of any investment before deciding to move forward. No investment, regardless of how risky it is, will be a fit for everyone.
The Pros of CD Investing
Most people, especially in a high-interest rate environment, are attracted to CDs because of the potential for a high return. In most cases, average CD rates tend to climb well above those tied to traditional savings and money market accounts (MMAs).
The best CD rates typically come from banks that pay competitive rates on long-term CDs and compound interest daily. Plus, most CDs are FDIC-insured up to the legal limit of $250,000 per financial institution. This means that your money is protected by the federal government even if the bank fails.
Another advantage to CD investing is that you have many types of CDs to choose from. With fixed-rate CDs, your rate is locked for the length of the term. So if you open a 12-month fixed-rate CD with a 2.5% APY, that’s the rate you’d keep for those 12 months.
You can also invest in a variable CD. In this case, the bank can lower or raise your interest based on the state of the Federal Funds rate and other factors. So this option may appeal to risk-takers or those who speculate interest rates will rise in the short term.
Several banks also offer jumbo CDs. This means they require a much larger minimum deposit. So while you might find a bank that lets you open a CD with as little as $100, jumbo CDs take minimum deposits around the ballpark of $10,000 to $100,000. The obvious pro here is that a larger deposit plus a high-interest rate equals a major return.
The Cons of CD Investing
One of the biggest drawbacks to CD investing is the early withdrawal penalty. Each bank and credit union sets its own rules on how to treat early withdrawals. In some cases, you’d lose a portion of the interest you had earned by the time you made the early withdrawal. In other instances, you would lose all the interest you earned plus a percentage of your principal. The point in time at which you made the early withdrawal can also play a role.
In any situation, taking your money out of your CD before its term ends is a bad idea and it really downplays the pros of CD investing. So you should open a CD for a term length you know you can stomach. Also, having built an emergency fund before you open a CD can prevent you from reaching into your CD for the money you suddenly need.
But whether you’re opening one CD or several, the term length matters. For instance, you may miss out on better opportunities to invest your money if it’s locked away in a 10-year CD. By then, interest rates may have had risen well above the fixed rate you may have started out with.
CD Laddering
Depending on your financial situation, one of the risks to CD investing is that you might need your money before the CD reaches maturity. And if you do, you’d likely face an early withdrawal penalty. To work around this potential issue, some people build CD ladders. This occurs when you open multiple CDs with different term lengths.
This method ensures you get a stream of income at different time intervals with each representing a rung on the ladder. For instance, you can get your return in three months, and then another in the next nine months. You can choose to use that money if you need it or reinvest it.
This option would also help you take advantage of FDIC protection if you have a lot of money to deposit because your investment is protected by up to $250,000 per financial institution. But despite all the potential advantages of CD investing, it’s not for everyone.
The Bottom Line
CD investing is another generally safe and low-risk way to invest. And it can earn you a stronger return than putting your money in a savings or money market account. Plus, you can open multiple CDs and establish a CD ladder in order to get a return plus interest at different time intervals.
But if you decide to dip your hand in the cookie jar early, the bank or credit union will hit you with an early withdrawal penalty. So always make sure you open CDs with maturity dates you can stick to. And it always helps to have enough in savings before you decide to secure your money in a CD.
Tips for Investing
- If you feel like you’d like to invest but are not sure where to start, you may want to seek a financial advisor who can help with all of your investment questions or needs. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- You can establish a CD ladder to build an emergency fund. It could be a good way to get a larger return on your money than just keeping it in a savings account.
- If you’re not sure about CD investing, maybe bonds are a better choice for you. So consider the differences in investing in bonds vs CDs.
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