Pros and Cons of Investing in a Certificate of Deposit

Benefits of Certificates of Deposit

A certificate of deposit (CD) is a maturity-based savings account offered by banks and credit unions to their deposit-seeking customers. When structured properly, it is a very safe investment vehicle that offers guaranteed interest income in exchange for a commitment to keep your money on deposit for a predetermined amount of time, the maturity term.

As implied, CDs have pros and cons. Let’s flesh out the most prominent considerations, starting with the pros.

Low Credit Risk

CDs are amongst the safest assets in which you can invest. They exhibit zero volatility, and, when properly structured, they are insured up to $250,000 for individual accounts and $500,000 for joint accounts. The Federal Deposit Insurance Corporation (FDIC) insures the accounts issued by banks, and the National Credit Union Administration (NCUA) insures the accounts issued by credit unions.

Guaranteed, Fixed Rate of Return

Beyond their low credit risk nature, the most prominent advantage of CDs is the guaranteed, fixed-rate income they offer. For fixed-income investors, the stability of the income streams is extremely valuable and regularly exceeds that of other guaranteed savings vehicles and mark-to-market fixed-income funds.

Assortment of Terms and Account Options

There are many types of CDs, most of which are structured as zero-coupon and make no cash payments until maturity. Focusing on this space of the CD world, there are a variety of terms and account options available to investors.

Most CDs have a maturity date that ranges somewhere from one month to five years — but terms are available for longer periods. Usually, higher interest rates are for longer-term CDs.

Common CD types include:

Jumbo CD

A CD that requires a higher minimum balance, often $100,000 or higher, than a standard CD. In exchange for the larger deposit, a jumbo CD usually offers a higher interest rate than other CDs. It can be a good option for savers with a large amount of money to invest.

No-Penalty CD

A CD that allows you to withdraw funds before maturity without paying a penalty. While the interest rate may be lower than other CDs, this type of CD provides more flexibility to savers who may need access to their funds before the CD’s maturity date.

IRA CD

A CD that is held within an individual retirement account (IRA). This type of CD offers tax advantages, such as potential tax deductions for contributions, and tax-deferred growth on the investment. An IRA CD can be a good option for savers who want to save for retirement while earning a guaranteed interest rate.

Bump-Up CD

A CD that offers you the ability to request a higher interest rate if market rates increase during the CD’s term. While this type of CD generally only allows one rate increase request, longer-term CDs may allow multiple requests. Bump-up CDs can be a good choice for savers who want to take advantage of rising interest rates.

Step-Up CD

This structure offers a predetermined rate increase at specific intervals during the CD’s term. This type of CD can provide savers with a guaranteed increase in their interest rate, even if market rates don’t rise.

Well-suited for Laddering

Sudden and significant interest rate movements are a risk for all investors. Fortunately, CD investors can largely mitigate this exposure via a strategy known as CD laddering.

A CD ladder entails buying several equal-value CDs with staggered terms. Each term represents a rung on your ladder, and each time a CD matures, you reinvest the money in a CD at the highest maturity rung on the ladder.

Consider this example:

Assume you have $50,000 to invest and put $10,000 into five different CDs (a one-, two-, three-, four and five-year CD). Each time one CD matures, you put the proceeds into a new five-year CD.

Essentially, you will have a CD maturing each year and you will have established the foundation to maintain an infinite investment position. Ultimately, this means a steady stream of income with a moderated level of interest rate risk given your exposure to varying CD rates and durations.

With interest rates at the highest point in over a decade, CDs have become a viable savings option for many investors who are wary of investing in the market or have specific defined-term savings goals (like purchasing a car or house). By utilizing varying maturities, investors can create a CD ladder that balances the benefits of guaranteed yield with the downside of CDs’ inherent illiquidity.

— Stephen Kates, CFP®

Drawbacks of Certificates of Deposit

CDs can be a great investment for some people, but they are not ideal for others. Deciding whether to invest in CDs depends on your investment objectives and tolerance for risk and having a sound understanding of how these instruments work and the risks to which they are exposed. On that note, let’s explore the most prominent disadvantages of CDs.

Lack of Liquidity and Flexibility

The most prominent drawback of CDs is their inherent illiquidity and inflexibility. As noted, a CD investment requires you to lock up your money for a predetermined amount of time. Early withdrawal is subject to a monetary penalty. The penalty usually equates to a certain number of months of interest, but in some cases, you may even see a loss of principal.

Inflation Risk

Notably, CDs are also exposed to inflation risk, which refers to the possibility of facing rising costs of goods and services that outweighs the fixed-rate income CDs produce.

This risk becomes more pronounced when investing in long-term CDs, which have a maturity period of five years or more. Runaway inflation rates can quickly erode the value of your investment, reducing your purchasing power and leaving you with less actual wealth when your CD matures.

Higher-yield Alternatives

CDs are a special type of savings product that offers investors meaningful yield enhancement due to their illiquid nature. While they offer higher returns than traditional savings accounts and some high-yield savings accounts, their returns are lackluster compared to stocks, bonds and alternative investments.

As a result, CDs are not recommended for investors with long investing horizons. For them, putting too much money into CDs results in excessive opportunity cost, an inferior risk/return profile and diminished potential for long-term wealth accumulation.

Tax Implications

When you invest in a CD, your deposit and the interest earned are usually not accessible until the CD matures. However, the issuing institution must periodically apply accrued interest to your account, and that interest is typically taxable. So even though you won’t receive the interest income until maturity, you’ll be taxed on it throughout the CD term.

When Is a CD a Good Idea?

To decide if a CD is suitable for you, consider your tolerance for risk, which is largely based on your immediate liquidity needs, willingness to bear volatility and investment time horizon. Generally, a CD makes sense for anyone that has ample liquidity and seeks a very low-risk investment with a guaranteed rate of interest.

This type of vehicle is most compelling in moderate inflationary environments; however, as discussed above, a CD laddering strategy can be an effective hedge against inflation. Just remember, with a CD, you must be willing to lock up your cash for a specified amount of time. Failure to do so will generally result in an early withdrawal penalty.

Incidentally, the best available CD rates are consistently about five times higher than the national average. For a quick summary of the highest-yielding CDs available, see Annuity.org’s best CD APYs.

When Is a CD a Bad Idea?

If you may need to withdraw your money before the CD’s maturity date, a CD may not be the best investment option for you. If you also have a long investing horizon and are concerned about inflation, a CD becomes a very poor investment option.

If you find yourself in this situation, you may consider investing in a mix of stocks, bonds, alternative investments, or even annuities, which could provide a better balance of risk and return.