Investing in certificate of deposit (CD) accounts provides you with several benefits. But as with anything in the investing world, you face some risk. So you have to weigh the CD pros and cons before you decide to open a CD account. This article will objectively examine those CD pros and cons to help you make an informed decision. But first, let’s examine what CDs actually are.
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. Nonetheless, there are many advantages to CD investing.
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).
Ultimately, however, 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 quarterly basis. Financial institutions also tend to offer higher APYs on long-term CDs.
So 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.
Advantages of 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 up to $250,000 per financial institution.
But despite all the potential advantages to CD investing, it’s not for everyone.
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 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 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 help to have enough in savings before you decide to secure your money in a CD.
Tips on Better CD Investing
- You can establish a CD ladder to build an emergency fund.
- If you’re not sure about CD investing, maybe bonds are a better choice for you. So consider investing in bonds vs CDs.
- If you feel like you’d like to invest but not sure where to start, you may want to seek a financial advisor. If you’ve never worked with one, we can help. Our SmartAsset financial advisor matching tool connects you with up to three financial advisors in your area who can assist you. Each specializes in different fields including investing and saving for retirement. In any case, you can review their credentials and even set up interviews before deciding to work with one.
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