When planning your financial future, it’s tricky to strike a balance between earning meaningful interest and keeping your money safe. But many individuals find that certificates of deposit (CDs) offer this exact balance.
Read on to explore the pros and cons of CDs and better understand whether this is the right saving strategy for you.
With a CD account, you deposit your money with a bank for a predetermined time period. In return, the bank pays you a fixed interest rate. When your CD matures, the bank returns your principal to you, plus any interest earned over the CD’s term. You can take the money (and run) or roll part or all of your proceeds over into a new CD.
CDs are quite flexible — you can choose from a wide range of terms regarding length and interest rate. And as you accrue interest, the bank adds those earnings to your principal, then calculates subsequent interest payments based on that new, larger principal (a process that’s known as compounding interest).
On the upside, CDs offer a straightforward structure and competitive savings rates, particularly when compared to standard savings accounts. Here are the main benefits of having a CD.
The only major difference between a CD and basic savings account (besides interest rates) is that you agree to keep your money tied up for a fixed period of time. So they’re pretty simple to understand, open, and manage.
With a CD, using the term and stated APY, you can calculate how much interest you’ll earn. Unlike a traditional savings account, where the interest can fluctuate, these returns are exact and guaranteed.
The Federal Deposit Insurance Corporation (FDIC) insures money in a CD account the same way it does checking and savings accounts — up to $250,000 per depositor, per insured bank. This guarantee makes CDs one of the lowest-risk investments you can make.
Plus, a CD isn’t tied to the stock market or even general economic conditions. Once you’re in a CD, your interest rate is set — there’s no volatility, and your rate won’t change during the term, no matter what happens in the market or with Federal Reserve decisions on interest rates.
The average interest rate on a high-yield savings account is 0.61%. On average, CDs are higher, at 1.86%.
CD terms run the gamut, from one month to several years. This means you can choose something that perfectly suits your current financial situation and long-term goals.
This also makes CDs great for short-term financial goals. If you know when you’ll need your money, you can select a CD term that corresponds with that timeframe. When the time comes to use that cash, you’ll have your principal, plus a little bit of interest, available to spend.
You can spread your savings across multiple CDs with different terms using a strategy called CD laddering. This ensures that you have some portion of your cash accessible at regular intervals and gives you a better chance of securing higher interest rates over time.
Some CDs are no-penalty, meaning you can withdraw anytime without restrictions, but these accounts also typically offer lower interest rates.
While CDs are an easy-to-understand, low-risk way to grow your savings, here are some of the disadvantages of CDs so you can decide whether the pros outweigh the cons.
Unless you’re okay paying an early withdrawal penalty — usually equal to a certain number of months of interest — or getting a lower interest rate overall, you have to wait until your CD matures to withdraw money.
The longer you keep your money locked up in a CD, the more you risk its growth not keeping up with the pace of inflation. As the cost of consumer goods increases in price, the purchasing power of your money decreases.
In this same vein, stocks — and other more aggressive investments — offer a better chance of generating returns that are higher than the current and future inflation rate. Generally, you can make (or lose) more money off of higher-risk investment products.
The interest rate you secure on a CD might look great today, but if interest rates rise, it might not feel like such a great deal tomorrow. Once you’re locked into a CD, you have to wait for its term to expire to get into an account with a better rate (unless you choose to open another CD).
While they vary considerably across banks and CD products, common certificate of deposit minimum balance requirements can be prohibitive. To earn a higher rate, some banks require a heftier minimum deposit.
Once you open a CD account, you can’t add to your principal. Only interest gets tacked on, not additional contributions, meaning you can’t do the work to help your money grow the way you can with other more flexible investments, like annuities.
No-penalty CDs exist, but they’re relatively rare. Expect to pay a fee for early withdrawals from a CD. These fees differ between banks but generally look like this:
Unlike many annuities and other investment types, CDs don’t grow tax-deferred — you’re responsible for taxes on interest earned in a CD account now, not come retirement.
Here’s an outline of the pros and cons to give you a bird’s-eye view and help you compare the two.
The best way to determine whether a CD is worth it is to consider your risk profile and savings goals. If you just want to earn a few dollars on your savings, CDs make it easy to sleep at night — they’re low risk, plus you know exactly what you’re getting and for how long.
Conversely, locking in an interest rate means you could be leaving money on the table, compared to other more lucrative opportunities.
As with any investment strategy, it’s crucial to understand how taxes will impact your earnings. Here’s an overview of the relationship between CDs and the IRS:
Decided this investment strategy is worthwhile? Here are a few things to consider when choosing a CD provider and contract.
Determine whether your CD savings strategy is short, medium, or long-term, and choose a contract length that aligns with this goal. If you plan to use a laddering strategy, decide on staggered term lengths for each CD to ensure you have regular access to funds while maximizing interest earnings.
If you think interest rates will drop in the near future, locking in a high rate on a CD now could be a smart move. For example, if you secure a 4% rate on a multi-year CD while rates are falling, your savings will continue to grow at that higher rate, even as new CDs start offering lower yields. So compare provider rates, check rate trends online, and lock in a fixed rate to make sure you’re earning more interest compared to what might be available in the future.
For greater flexibility — especially if you’re using a CD laddering strategy — consider CDs with low minimum deposit requirements. This allows you to distribute your cash across multiple CDs (taking advantage of different maturity dates) and still keep funds available for other potentially higher-yield investments.
While annuities often come with more risk and increased fees compared to CDs, that’s not always the case. Some insurers remove the middleman to eliminate hidden administrative, maintenance, and commission costs — something you won’t avoid when buying a CD. Plus, you’ll typically get a higher rate of return with an annuity, so more money stays in your pocket. There’s an annuity for almost every goal, usually offering increased flexibility compared to CDs.
This communication is for informational purposes only. It is not intended to provide, and should not be interpreted as, individualized investment, legal, or tax advice.
