What is a CD? (Certificate of deposit)
A CD (or Certificate of Deposit) is a financial instrument that holds your money for a pre-determined amount of time in exchange for paying interest that is (hopefully) higher than what a regular bank savings account would typically pay.
The Federal Deposit Insurance Corporation (FDIC) insures most bank-issued CDs up to $250,000 per account holder. CDs began to be insured by the FDIC when it was created in 1933.
CDs have long been a popular investment choice for investors who want to keep their money safe and close, while enjoying an attractive interest rate. But investing is not ideal in all situations, nor the right solution for every investor.
- How does a CD work?
- Fixed rate
- Determined time
- Most CDs have early withdrawal penalties
- CD or savings account?
- Where can I get a CD?
- Current CD prices
- CDs or Mutual Funds?
- Should I invest in a CD?
- The impact of inflation on investment returns
- Final Thoughts
How does a CD work?
The process of buying a CD is quite simple. Unlike a mutual fund or ETF, you cannot make regular contributions to a CD. You buy the investment in advance, in a single payment. Minimum deposit amounts generally range between $500 and $2,000, depending on where you purchase your CD. Here’s a closer look at three key features of CDs.
The appeal of CDs is that they offer a fixed interest rate that is more attractive than the offering bank’s savings interest rate.
The rate you get on your CD generally stays the same, although some CDs have bump clauses that allow the account holder to increase the rate once during the term of the CD if interest rates have risen.
Thus, account holders open the CD to get the highest rate, and the bank is assured that it can use the money to earn money for the specified duration of the CD.
Another identifying factor of a CD is that it has a fixed duration. You will know from the start of your CD purchase whether your investment will be locked in for six months, 12 months or up to five years. Generally speaking, the longer the lock-up period, the higher the interest rate.
The fixed term makes CDs less liquid than a passbook.
Most CDs have early withdrawal penalties
Due to the fixed terms of CDs, banks typically charge early withdrawal penalties if you breach your CD contract and choose to cash it in before the maturity date.
Early withdrawal penalties on CDs are usually a portion of the interest you would have earned had you held the CD for the full term. For example, a 12-month CD might have a pre-withdrawal penalty equal to three months of earned interest, whether you earned it or not.
CD or savings account?
When deciding whether to open a CD or keep your money in a savings account, it’s important to consider a few factors, starting with the interest rate.
For example, while researching for this article, I noticed that Discover was currently paying 1.30% interest on its High Yield Savings Account. But Discover pays a minimum interest of 2.00% on its CD offerings. If the difference is big enough that you’re willing to lock in your money for a period of time, go for it.
Second, make sure you won’t need the money you put on a CD before it matures.
In other words, if you think you need another vehicle in the next 12 months, don’t lock your car savings into a 2-year CD.
You could risk losing the interest you expected to earn if you had to buy that car in three months because you would incur a penalty, or you might have to take out a temporary loan to get the car.
In short, if you’re okay with locking up your money and you’re attracted to the higher interest rate, go ahead and get that CD.
Where can I get a CD?
CDs are available at almost any bank, including the most popular online banks. As you will see in our rate comparison below, online banks pay higher interest on certificates of deposit.
Current CD prices
If you have decided to invest in a CD, you can always check with your local banks and credit unions to find out what types of interest rates they offer.
Here are some examples of CD rates from popular banks at the time of this writing:
As you can see, online banks usually offer the best interest rates on CDs (and the like). Brick-and-mortar banks, in part due to higher overhead, simply cannot compete with online banks’ CD rates.
CDs or Mutual Funds?
The deciding factors are pretty clear when choosing between a CD or a mutual fund.
CDs fall into the category of security assets. Your principal balance is not only guaranteed by the issuing institution; the FDIC also insures it in most cases.
Unless you choose to redeem your CD before the term you have committed to, you will get your principal investment back, plus the interest promised to you.
Mutual funds do not have the same guarantees and, with the exception of a money market fund, are much riskier than CDs. Most mutual funds are made up of individual stocks that constantly rise and fall in value.
The advantage of mutual funds over CDs is the potential for higher returns over the long term. As an example, look at the 10-year annualized returns (2010-2020) of some of today’s most popular long-term mutual funds (pre-pandemic return averages):
- T. Rowe Price Health Sciences Fund (PRHSX): 20.3%
- Vanguard Wellington Fund Investor (VWELX): 9.7%
- Fidelity Total Bond Fund (FTBFX): 4.4%
- Admiral of the Vanguard 500 index fund ((VFIAX): 13.8%
- Fidelity Strategic Dividend and Income Fund (FSDIX): 9.8%
Compare that with CD interest rates from the same time period (2010-2020), and you’ll find you’d be lucky to earn just over 2% on a CD in 2010, when rates have steadily fallen as the decade passed.
If you only look at average interest rate earnings, the mutual fund is good for long-term investors. However, mutual funds are much riskier when investing for a shorter term (three years or less, for example).
Should I invest in a CD?
Before buying a CD, determine what your investment objective is. If your main priority is to protect your capital investment, a CD (or savings account) is probably your best bet. And if you can afford to lock in your funds for a pre-determined period of time, the CD probably trumps the savings account.
If your primary goal is to generate the highest returns possible over the long term, you’re better off investing in the market, such as stocks, mutual funds, or ETFs.
The impact of inflation on investment returns
Before investing in a CD, it’s important to realize that your returns are unlikely to stay ahead or even keep up with inflation. That’s especially true here in 2022, when inflation hit levels we haven’t seen in decades.
Your money loses its purchasing power each year that your investment returns do not keep up with the rate of inflation. That’s why it’s always important to work to protect your portfolio against inflation.
CDs don’t pay a high enough return to do that. That said, if investing in the stock market has you losing sleep at night, a CD will ease your anxiety. CDs can also be a good choice for consumers who find it difficult to save money and want to save money in an emergency without being tempted to touch it.
Since there is very little risk of loss and you can access the money fairly quickly if the need really arises (even if you have to take a penalty), using a CD for this purpose might be a good idea. .
However, CD investing will leave you very disappointed if you are looking to invest for the long term (over five years) and are comfortable with the risk/reward ratio of other investments such as mutual funds or ETFs.
Certificates of deposit can be useful if you’re looking for a short-term investment that has little or no risk of capital loss and offers a guaranteed rate of return.
However, CDs aren’t your best option if you’re looking for an investment that will beat the rate of inflation and help you grow your wealth over the long term.