Certificates of deposit or CDs are savings vehicles typically offered by commercial banks and credit unions. CDs usually offer a higher interest than regular bank savings accounts. In exchange for this higher rate, you will need to keep your money in the CD for a set period of time that can range from a few months to several years.
Are CDs worth it? When answering this question it's important to consider your short and intermediate-term savings goals as well as the pros and cons of CDs. The answer will vary for each individual’s situation.
Pros of investing in CDs
CDs are safe-principal is protected
As bank deposit accounts, CDs are insured up to $250,000 by the FDIC, joint accounts offer $250,000 coverage for each account holder. There is no risk of loss up to the FDIC insured amount.
If you need to set aside some money for a few months or even several years, CDs can be a good alternative to a savings account. The money is safe and the interest rate will likely be more competitive.
Fixed rates
CDs offer a fixed interest rate for the term of the CD. This means your returns are known and predictable allowing you to plan on this portion of your cash flow. This can be helpful if you are setting aside the money for a purchase and you want to be sure of the amount you will have when the CD matures.
CD ladders provide long-term stability
One strategy for investing in CDs is to ladder several CDs by maturity date. Laddering means owning several CDs with different maturities. You might stagger several CDs with maturities every six months. This will provide an opportunity to purchase another CD at the longer end of the ladder or reinvest the money elsewhere.
Cons of investing in CDs
You lose access to the money
When investing in a CD, you agree to leave the money invested in the CD for the entire term. This might be as little as three months or it could be as long as five years. If you do need to access the money sooner there will be a penalty equivalent to several months or even years-worth of interest.
Additionally you cannot add more money to the CD. For example if interest rates drop, you can’t add additional money to a CD you may be invested in with a high interest rate.
Early withdrawal penalties
Early withdrawal penalties on CDs can be quite steep in some cases and can negate all or most of the advantages of investing in the CD. The penalty will typically range from 10% of the total interest that you would have earned to as much as 30% or more of the total interest or more.
While certainly unforeseen situations arise that could necessitate taking an early withdrawal from a CD. But if you have a concern that you will need the money sooner than the term of the CD, a CD is probably not the right savings vehicle for your savings needs.
Missed opportunities
One of the advantages of investing in a CD is that you lock in the CD’s interest rate for the full term of the CD. This can also be a disadvantage as well. If interest rates turn up, the money invested in a CD at a lower rate cannot immediately be withdrawn and invested in a higher rate CD or other type of savings vehicle paying a higher rate.
When investing in a CD is worth it
A CD can be worth investing in under a number of circumstances. Some examples include:
- Locking in an interest rate for a near-term purchase. This might be a car, a down payment on a house or perhaps your child’s college tuition. By using a CD that matures roughly at the time the money is needed for this purchase, you will have locked in the interest earned and your money will be secure until it is needed.
- You are looking for a secure place for some of your money over time with an interest rate that is typically better than high-yield savings accounts or other savings vehicles. A CD might be a good option in this case.
- CDs can be a component of your fix-income strategy. By using a CD ladder when each CD matures you can make a decision whether to invest in another CD or invest the money elsewhere if you find a better option.
Alternatives to CDs
There are a number of alternatives to CDs including:
- Treasury bonds and bills. These are risk-free fixed income securities and come in maturities ranging from three months to 30 years. Treasury Inflation Protected Securities (TIPs) are indexed to inflation and offer protection should inflation pick up in the future.
- Mutual funds that invest in short-term bonds can offer decent rates. While they will be subject to interest rate risk if rates rise, this risk is less than funds investing in intermediate-term or long-term bonds.
- High-yield savings accounts pay a bit less than CDS, but offer access to your money with no lock-up.
CDs are one vehicle investors can consider for the fixed income portion of their investment strategy. They can offer a stable and secure vehicle for cash needed over a specific period of time or a secure parking place for some of your cash.
There are a number of alternatives to CDs. It is best to consult with a financial advisor to help determine the best place for your cash and fixed income investments.