The pros and cons of a CD: how to know if a certificate of deposit is the right investment for you

Yahoo! Finance: Top Stories / 2023-03-28 20:07



Mapping out plans to build your savings can be challenging, especially when interest rates fluctuate. A certificate of deposit (CD) is a good alternative if you're risk-averse when investing.

A CD is a type of savings account that allows people to earn interest at a fixed rate that's often higher than what's available with traditional savings accounts. However, CDs can also have some downsides given their nature of holding funds for a set term. Here are a few important things to consider to help you decide if a CD is right for you.

How does a certificate of deposit work?
A CD has an interest rate that will not change nor the time your money is locked in for. So after the term of the CD you choose ends, you'll have access to the deposited funds and interest earned on it.

Brad Stark, certified financial planner and co-founder of Mission Wealth, a wealth management firm in Santa Barbara, CA, says you can purchase CDs in brokerage accounts to help with simplicity. Many brokerage firms have relationships with different banks, allowing people to diversify their investments without opening multiple accounts.

By buying CDs, Stark explains, people are essentially making a promise with a bank. That promise is providing funds to an institution in exchange for being paid back with interest later.

"It's a loan you're making to the bank for a set period of time," Stark says.

Pros of certificates of deposit
Aside from a strong fixed interest rate, there are even more reasons that make CDs appealing, from the low level of risk associated with them to the options that can fit someone's ideal savings plan.

Higher APY than other types of savings accounts
While it's true that the APY will likely be higher than a traditional savings account, it's important to consider the timing of when the CD will be opened. If it's done when savings rates are on the lower end, it doesn't rack in as much growth as it could have if it'd been done at a time when savings rates are high.

And another factor you'll want to pay close attention to when you shop around for CDs is considering the interest rate in relation to the timeframe of the CD. "As you commit your money to longer periods of time to lock it up, you should be compensated with higher interest," Stark says.

Your money is secured
A CD comes with coverage from either the Federal Deposit Insurance Corporation (FDIC) or the National Credit Union Administration (NCUA), a major draw for people who want the peace of mind that their money is safe even if a bank fails as some did during the 2008 recession. Banks typically insure up to $250,000 per ownership category.

Flexible account options and wide selection of terms
There's plenty of room to find a CD that matches people's varying savings plans and the time they're hoping to reach them. Whether it's saving for just a few months to boost an emergency savings stash or collecting extra cash years before starting a family, CDs offer an option to fit those needs.

On top of being able to choose a CD that matures anywhere from three or six months to five years, the rates to choose from will also have differences. As of March 23, 2023, the average rate for a one-year CD is 1.49%.

CD laddering
One method to consider is placing money in multiple CDs rather than one. This approach of layering CDs can help maximize your savings and get the funds placed in them returned at a steady pace. Scott Van Den Berg, a certified financial planner at Century Management, a financial advisory firm in Austin, TX, says building out a portfolio of CDs can have major benefits.

For one, it helps CD users deal with instances in which an unforeseen expense arises, and they need access to their savings. With laddering, some risk associated with not having immediate access to the funds is mitigated since the maturation date for the funds could be just around the corner. One way to approach it is by getting a CD that matures in six months, one in a year, and another in 18 months.

"That at least gets you that money back and you can then just reinvest it," Van Den Berg says.

Cons of certificates of deposit
To an extent, CDs can be a way of playing it safe. And in doing so, there's an opportunity cost that comes with not pursuing other savings options that could have resulted in more money or drawn in money more quickly. This is particularly important to consider if you haven't reached retirement age.

"If you're 85 or 90 years old, you want all your money to be safe and your time horizon is really short, you could put CDs in an IRA," Stark says. "If you're 40 years old, and you have an IRA and CDs in there, what an opportunity [to earn more] you're missing." Plus, the time agreement of a CD can be inconvenient if you can't hold the funds there for the duration of the agreement and are then subjected to early withdrawal fees.

Returns aren't as high as investing in other places like stocks or bonds
Both Stark and Van Den Berg note other areas where it's possible to have stronger investment growth than with a CD.

Stark suggests considering stocks in a diversified portfolio if the time horizon for your financial needs is longer than 10 years.

"While this path is volatile, time tends to heal most short-term investment wounds," Stark says. "Whereas time is the enemy to CD investing."

Inflation isn't factored in with a locked APY
Although CDs might not seem risky at first glance, they can hurt your savings goals in times of inflation. That's because the APY can't be adjusted, Stark explains, so an interest rate that once seemed stellar would no longer keep up with the demands of the moment.

"Inflation really took a toll on you and your interest went from double digits to zero," Stark says. "And in the meantime, prices and everything went higher. So your purchasing power just got decimated."

Taxes owed on accrued interest
Interest earned is always taxed unless it's in a retirement account, so that's a factor to consider when deciding if a CD will provide the desired savings results after accounting for taxes.

It's also not something you can put off. Those earnings must be reported if you've earned $10 or more in interest on a short-term CD that matured the same year you bought it. And if the CD has a life beyond a year, then the person must pay taxes on the interest accrued yearly.

Penalties for accessing funds early
When people sign up for a CD, they agree not to touch the money for a set period. Of course, things happen and sometimes people need the funds they had initially thought could be set aside.

Chances are, the bank won't allow people to pull their funds. In exchange for taking the money back before it has matured, banks will charge a penalty, often calculated as a number of days' simple interest at the rate of the CD. But the federal government has no cap on early withdrawal penalties, so it can vary.

What you need to open a certificate of deposit
Social Security number for U.S. citizens or an individual taxpayer identification number for others.

Date of birth of the account holder. It helps to present documentation such as a birth certificate to prove identity.

A government-issued ID like a driver's license or state identification card.

Proof of address. Think bills or a lease agreement.

Contact information such as a phone or email

Information for the funding account, such as the routing and account number.

Frequently asked questions
Is it worth putting money into a CD?
Experts say that, generally, it can be. At the very least, it's preferred over simply having the money in a checking account or cash under your mattress at home where it can't grow any interest. If you're looking for a low-risk option from a bank you trust, then a CD is better than nothing. It all comes down to making a fully informed decision where you've read the fine print and know the penalties for withdrawing early.

What is better, a CD or IRA?
Since an IRA is a retirement account that can own stocks, bonds, and CDs, it's better to ask if CDs are appropriate to hold in an IRA. And, they can be, depending on your age. That's because CDs aren't the most lucrative long-term move if you still have a ways to go before retirement.

How much does a $10,000 CD make in a year?
It's hard to say with certainty as it depends on the rate of the specific CD. But, as an example, a CD with a 5% APY earns $500 in one year. So if you have a CD with a 12-month term, you would withdraw $10,500 once the CD matures.

This story was originally featured on Fortune.com

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