The Benefits and Drawbacks of Certificates of Deposits

With guaranteed returns and minimal risk, certificates of deposits, or CDs, are a popular investment option for people looking to stash their extra savings and even investors diversifying their portfolio. Certificates of deposit are offered by most banks and credit unions, so they're easily accessible. They also function similar to savings accounts, which makes them one of the easier investment options to understand.

CDs are safer than buying stocks and generally offer a better return than savings accounts. The biggest trade-off is that you have to lock your money to get that higher rate. Before you commit to parking your cash for several months—or years—consider the pros and cons.

What Is a Certificate of Deposit?

A CD, or certificate of deposit, is a type of deposit account that offers a fixed interest rate. In exchange for the higher rate, you agree to keep your money deposited for a specific amount of time. CDs offer a low-risk way to earn interest on money you don't need right now, but they don't make sense for every situation. Understanding the pros and cons can help you evaluate whether a CD is right for you.

5 Benefits of CDs

CDs have several attractive features that make them a good choice for earning interest on your extra money.

Fixed Rates and Terms

Investing in a CD gives you a predictable return in a specific timeframe. When you purchase a fixed-rate CD, for instance, your rate and term are locked in, providing you with consistent growth until maturity. Market rates may fluctuate, but your CD rate is safe.

Higher Yields

CDs often offer higher yields compared to other types of deposit accounts, like traditional savings accounts, without additional risk and volatility. Longer-term CDs typically offer higher rates in exchange for keeping your money deposited for longer. 

Malik S. Lee, CFP and founder of Felton & Peele Wealth Management, told The Balance by phone that offering higher CD rates is one way banks boost their reserves to increase lending. Lee says this is commonly seen at community banks and credit unions.

Low (or No) Fees

While some CDs may have a minimum opening deposit requirement, they typically don't come with additional ongoing fees. Depending on the bank, savings and money market accounts may have monthly fees that can eat away at your return. That's if the APY is high enough to offer a noticeable return.

Here is a sampling of savings products and their monthly fees based on The Balance analysis.   

Safe Investment

Purchasing a CD from an FDIC- or NCUA-insured bank or credit union means your deposits are safe up to the maximum of $250,000. Even if the bank fails, your deposits are guaranteed.

When you withdraw the money from your CD, you'll generally receive your deposit and the interest you've earned. The exception is when you cash in your CD before it matures. In that case, you could lose some or all the interest you earned, plus some of your deposit depending on the terms of the CD.

Variety of Options

CDs come in variations, which gives you a good selection to consider. You can choose based on how long you want to have your money invested—short-term CDs for as few as 30 days, for example, or long-term CDs for five or 10 years. There are also variations in how you can earn interest:

• Fixed-rate CD: Maintains the same rate for the entire term
• Variable rate CD: Has a rate that fluctuates with the market
• No penalty or liquid CD: Allows fee-free early withdrawals
• Brokered CD: Sold by brokers or investment professionals often for a fee; may offer higher yields and have longer terms

5 Drawbacks of CDs

The drawbacks of investing in CDs aren't deal breakers, but understanding potential risks allows you to make a well-informed decision.

Low Rates

If you shop around, you may find that sometimes, putting money in an online savings account beats locking it away in a CD. "High-yield savings accounts are so competitive, they usually offer better rates on timeframes under 12 months," says Lee. For terms between three and five years, Lee suggests exploring options like a multiyear fixed-rate annuity, which has some tax advantages. And, during periods of high inflation, Lee suggests Series I Savings Bonds as an option.

Here’s a sampling of the APYs of various savings products based on historic average APYs analyzed by The Balance as of August 3, 2020.

Poor Liquidity

Since you must commit to a fixed term, you can't access the money deposited in your CD before maturity without paying a penalty. If you have to cash in a CD to cover an unexpected expense, expect to lose a few months of interest earnings.

Keeping some money in a more accessible account, like a savings account, gives you a source of funds to turn to for emergency spending, since you're officially allowed six withdrawals per month. (This rule, which is part of the Federal Reserve’s Regulation D, has since been paused, although banks are able to set limits if they choose to.)

However, Lee says compared to some other types of investments, the early withdrawal penalty—if applicable—can be minimal.

Taxes

Interest earned on a CD is subject to taxes. "You must claim your interest as taxable income on your tax return in the year it's earned, not just the year the CD matures," says Lee. Depending on your income and deductions, this could lower any tax refund you were due to receive. Or you could end up owing additional taxes if you underpaid for the year.

Reinvestment Risks

Many CDs automatically renew unless you inform the bank not to renew your CD before it matures. Otherwise, your deposit will be reinvested (referred to as a “rollover”), usually at the bank's current rates, causing you to miss out on the opportunity to shop around for better rates. You can cash in your CD after it reinvests if you really need the funds, but you'll be subject to an early withdrawal penalty.

No Wealth Building

The yields on CDs aren't always high enough to make a noticeable impact on your portfolio. Investing in higher yield equities like stocks or index funds may provide more growth on your money, especially over the long term.

You also can't add funds to most CDs once you've locked in, which prevents you from earning more interest on a higher balance. While CDs have advantages, they're not a tool for building wealth.

Is Investing in a CD a Good Option?

Like most financial products, CDs are useful in certain situations—when the CD rates are higher than rates for high-yield savings accounts, for instance. "I typically look for the breakpoint where the CD produces a higher return than high-yield savings accounts, which is usually between one and three years," says Lee.

Since better rates generally coincide with longer terms, you must be willing to commit to locking your money away for several months to a few years. If you might need the funds before then, a CD wouldn't be the best option.

If your goal is to build long-term wealth, there are better options than CDs. The rates aren't high enough to significantly increase your net worth.

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