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A certificate of deposit, or CD, is a conservative way to grow your money, and is considered one of the safest investments that are currently available. If you plan to keep your money in one place for several years, but don’t want to worry about market volatility, then a certificate of deposit might be a good choice, as you can earn more money than if you kept your money in a traditional savings or money market account.
In this article, we’ll discuss the advantages and disadvantages of using certificates of deposits as part of your investment strategy and for locking money aside for the future.
Advantages of Using a Certificate of Deposit
There are several advantages to owning certificates of deposit. We’ll cover these below.
CDs often have fixed interest rates for the lifetime of the term. You can use a calculator to determine how much money you’ll have at the end of a particular CD’s life.
CDs don’t suffer from volatility like you’d see investing in the stock market. Instead, you will get the expected return so long as you don’t close your CD early. For example, if you opened a $1,000 1-year CD at 1%, you would have $1,010 at the end of the term.
You Can Create a CD Ladder for Passive Income
A CD ladder is when you several CDs at once with incremental dates of maturity. This provides you with a steady stream of passive income that you can continue indefinitely.
As an example, you might open 1-year, 2-year, 3-year, 4-year, and 5-year CDs, and once the 1-year CD matures, you could continue by opening another 5-year CD and repeatedly open 5-year CDs each time the next CD matures.
By doing this, you would be earning income every year and reinvesting the principal to create a safe and steady stream of income annually.
Your Money is Safe
CDs are a safe place to keep your money because they are FDIC-insured, so long as you open a CD in a bank that has FDIC insurance. FDIC insurance currently covers $250,000 per depositor, for each account category, per financial institution.
If you use a credit union instead of a bank, the NCUA insures your money up to the same amount.
What this means is if your financial institution shuts down, you won’t lose any money, so long as that bank is insured and so long as your CDs total less than $250,000.
There Are No Monthly Maintenance Fees
Some savings accounts and money market accounts charge monthly fees, such as if you don’t have more than the minimum monthly balance. On the other hand, most CDs don’t charge any fees. This means you keep every bit of interest that you earn, so long as you don’t withdraw money early.
Your Income is Predictable
CD income is predictable in that you always know what you’ll earn at the end of the term. We mentioned this earlier when we spoke of guaranteed ROI. Not only is your ROI guaranteed, but you’ll know ahead of time how much money you’ll have by using a simple calculator.
Returns Are Often Better Than Savings Accounts
CDs, especially long-term CDs, have greater interest rates than typical savings accounts. If you plan to lock your money up for a while, you’ll earn a greater return with a CD than you would with a savings account.
This can be handy if you need your money in the future and want to grow it safely while also getting a greater return than you would in a typical savings account.
Higher Returns For Longer Investment Periods
CDs often offer higher interest rates when you deposit your money for longer periods of time. This allows you to earn more money if you don’t need your initial investment for some time. For example, a 5-year CD might offer a much greater return than a 1-year CD.
CDs Don't Require a Lot Of Money to Open
Unlike some other investment options, CDs don’t require much money to open one. It’s common to require a minimum of $500, but some will allow as low as $100 or even less. You might not earn much money with a low investment, but that won’t stop you from opening an account.
Disadvantages of Using a Certificate of Deposit
While CDs do have some nice advantages, there are some disadvantages to be aware of as well.
Your Money is Harder to Access
A CD has limited liquidity, and you will typically have to pay a penalty if you decide to withdraw your money before the maturity date. Depending on the CD, you may lose some of the interest or some of the initial principal if you withdraw early.
You can mitigate this disadvantage by using a CD ladder, which gives you access to pieces of your money incrementally.
Risk of Inflation Can Cause You to Lose Purchasing Power
Inflation risk exists with CDs as interest rates often go up slower during periods of inflation and drop faster during deflation periods. This means that if you choose to invest in CDs, you have a risk of losing purchasing power.
It’s understood among investors that it’s common for inflation to be greater than the return of a typical CD.
Low ROI Compared to Other Options
As mentioned above, CDs often have a relatively low return on investment. Compared to investing in stocks, bonds, real estate, and other investment choices, CDs typically come in at one of the lowest ROIs.
Despite having one of the lowest ROIs of other investment choices, CDs are still considered one of the safest choices you can make, though you’ll want to keep in mind that you may lose purchasing power with a CD.
CDs May Have Early Withdrawal Penalties
Many CDs lock up your principal until the end of the term, and you’ll have to pay a fee to withdraw your money early. That fee can be part of the interest or part of the initial principal.
These penalty fees can eat up your returns, so you should read the terms carefully before you open an account.
Wrapping It Up
If you have cash that you don’t need for some time and don’t want to risk investing in the market where there’s volatility, a certificate of deposit might be right for you. Most CDs are backed by FDIC-insurance, meaning this form of investment is safe and reliable.
That said, if you’re looking for a higher return on investment and don’t mind risk, there are many other investment options out there where you may see better results.