Investors have access to a number of different opportunities to grow their portfolio. One of the most common options is the certificate of deposit, often referred to as a CD. It’s often considered a savings option more than an investment option and most financial institutions offer them in some form. Online financial institutions often offer better interest rates and additional options that can limit potential penalties should something unexpected happen.
Are CDs the right savings tool for you to use? Here are the certificate of deposit pros and cons to consider before locking up your cash.
The Pros of the Certificate of Deposit
1. They are a very safe investment option.
In the United States, CDs are actually insured by the FDIC or the credit union alternative. They are insured to the maximum amount that the law allows, so even if the financial institution fails, the money can be recovered. Since most financial institutions are expected to be around for the next 5 years, there is virtually zero risk of loss when it comes to a certificate of deposit investment. Insurance amounts are up to $100,000 currently.
2. Consumers have interest rate options.
CDs can be offered as a variable interest rate product or as a fixed interest rate product. This means that consumers have a few options when deciding which certificate of deposit is right for them. A fixed rate over a 3 year term means that if interest rates go down, the same interest rate will get paid until the CD expiration date. On the other hand, if interest rates go up, the CD will be locked into the lower rate.
3. It provides a steady amount of interest income.
Although the interest rates are based on the prime rates and have been fairly low for consumers, the amount of income they earn is steady and is often more than what a standard savings account would earn. There’s not the same amount of risk as stocks, bonds, or mutual funds offer either, so there will always be the cash on-hand if needed. This is why they are a good savings alternative for many people.
4. CD ladders make it possible to access cash when needed.
Because cash needs to be locked away in a certificate of deposit, many investors will create what is known as a CD ladder. This creates a way to access portions of liquid cash at various points of time throughout the year without penalty if necessary. If an investor has a CD which matures every month, then there will be money available for emergency expenses without experiencing a penalty.
5. The income is predictable.
The yield that a CD can provide is known before the investment is ever made into it. This means investors will know exactly what their outcome will be at the time they make their investment. That’s something that many other products can’t do. If the certificate of deposit is managed through an online account, then access to this cash is possible no matter where someone might live, which further increases the predictability of this investment option.
6. The CD can be used as collateral for new debt.
For consumers who may need to purchase a big ticket item, like a vehicle, the certificate of deposit can be used as a form of collateral to obtain the new loan. This can be especially beneficial if the loan originates from the same bank that holds the CD. Some consumers can even receive a lower interest rate on their long term loan because the collateral covers a portion of it should a default occur.
The Cons of the Certificate of Deposit
1. The money is locked away for a specific amount of time.
The standard certificate of deposit will require the cash to be kept on deposit for a specific period of time. Depending on the product that is chosen, this could be 6 months or 5 years. There are some no penalty CDs that are offered by some financial institutions if early cash access is required, but these often have lower amounts of interest that get earned over the passage of time.
2. There is a high inflation risk.
Certificates of deposit tend to lag behind inflating interest rates, but they’ll drop quickly when rates are on their way down. This means that over time, the purchasing power of the cash contained in the CD could lose its overall value. If the return on your 5 year CD is 1.2% annually and inflation grows at 1.4% annually, then your purchasing power is reduced by 0.2% annually and there’s not much that can be done about that fact.
3. Current rates provide a fairly laughable return.
Certificates of deposit are generally attractive when interest rates are high. In Q4 2014, the average interest rate on a 3 year CD was 1%. An investor putting $2,000 into this CD would not only lose access to this cash for 36 months, but upon maturity the total yield would only be about $60. It’s a better return than the average savings account, but even many rookie investors can achieve a better return using other tools.
4. Higher interest rates generally come with a lack of insurance.
There are some financial institutions that are offer 3x the going interest rate on CDs, but this benefit comes with a catch: there’s no FDIC insurance available. This means if the financial institution goes under and shuts its doors, then that CD becomes a loss. If the goal is to lock money away so that it is safe, this isn’t a very good option because the risk factors are enhanced for what amounts to a relatively small overall gain.
5. They don’t transfer if you need to move.
If you start a CD at a local bank in New York that has a 2 year maturity date and you have to move to San Francisco, then you won’t be able to transfer that CD with you. It must stay at the bank where it opened or the holder of the CD must cash it out and experience a financial penalty for doing so. If this process repeats itself 3-4 times over the course of a decade, it would be possible to have several CDs in several different location that would need to be managed.
CD’s Are Good When the General Stock Market Highers and Lows Need to be Avoided
The yield that comes from this investment product are often low, but the return is guaranteed if purchased through an insured institution. By examining all of the certificate of deposit pros and cons, each household can decide if this is the best way to protect their cash while still receiving a return.
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