Key takeaways
- CDs earn a guaranteed return over a set period of months or years. They're considered safer than the stock market and can offer a better return than other bank deposit accounts.
- CDs charge an early withdrawal penalty if you cancel before the end of the agreed term. They're best if you know when you'll need your money back from the investment.
- While CDs are safer, stocks and mutual funds typically have better returns over many years. A diversified portfolio should have a mix of these investments.
If you want to invest your money, you have plenty of options. On one hand, you have bank accounts with guaranteed returns, like savings and money market accounts. On the other hand, you have higher-return but higher-risk investments like stocks and mutual funds in a brokerage account.
A certificate of deposit (CD) strikes a balance between the two as it combines safety with a decent long-term return. But CDs aren't suitable for every situation. So, is a CD a good investment for you? Read on to find out.
5 Advantages of investing in CDs
CDs are a popular investment. Here are some of the top benefits:
Predictable returns
When you open a CD account, you pick how long you want it to last. The term can range from a few months to many years. During this time, you earn a guaranteed interest rate on your deposit before getting everything back at the CD maturity date.
You can see your exact growth before signing up, which helps with budgeting for future goals. For example, say you put $10,000 in a 12-month CD account with a 5% annual percentage yield (APY). You'll earn $500 and have $10,500 by the end of the year.
Safe and protected against losses with FDIC Insurance
CDs are bank deposit accounts with Federal Deposit Insurance Corporation (FDIC) insurance. The bank guarantees your interest rate and repayment of your money. If the bank goes bankrupt, the government promises to repay your deposit, up to $250,000 per depositor per bank for each account ownership category. It's not like a bond, where you risk losing your money if the issuer goes bankrupt.
Better interest rates than other bank accounts
CD accounts typically pay higher interest rates than traditional savings accounts and money market accounts. Banks and credit unions usually offer better CD rates because you agree to leave your money with them for the term. You give up some cash liquidity to earn more.
Locks in your interest rate
With most bank deposit accounts, your interest rate depends on market rates. You earn more when rates go up and less when rates go down. With a CD account, you can lock in the current rate for the entire term. You don't have to worry about your earnings suddenly falling in the future.
A variety of possible CD options
CD accounts come in term lengths ranging from one month to five years or longer. You can also choose from different CD products. For example, a jumbo CD account requires larger deposits and pays a higher interest rate. A bump-up CD account lets you increase the rate if market rates go up after you sign up. You can find a CD type that best matches your goals and timeline.
5 Drawbacks of investing in CDs
Possible penalties for canceling early
When you invest in a CD account, you agree to keep your money with the bank for the entire term. The bank could charge early withdrawal penalties if you withdraw or cancel before then. In that case, you usually forfeit several months of interest earnings.
Less upside potential than market investments
CD accounts earn less on average than the stock market and mutual funds. That's the trade-off of getting a guaranteed return versus the unpredictable swings of market investments. When you lock in a CD rate, it might not grow your money enough during high inflation periods when prices are going up.
Can require a large minimum deposit
CD accounts may require a minimum deposit of $1,000 or more. CD accounts paying the highest rates could require a five-figure deposit.
Difficulty with timing interest rates
When considering a CD account, part of the decision is predicting future interest rates. You can renew at the end of the term but only at the new CD rates. Locking in a long-term CD would be a better investment if future rates fall but bad if rates later go up. Alternatively, a short-term CD would be a better investment if rates go up later but bad if rates fall. This is known as reinvestment risk. One possible solution is to spread your money across a mix of short-term and long-term CD accounts, known as a CD ladder.
Taxes on interest earnings
You owe income tax on your CD interest earnings each year. This is true even if you reinvest the money back into another CD account.
When it may make sense to invest in a CD
Now that you've seen the pros and cons, when are CDs worth it as an investor? A CD account can make more sense in some scenarios than others.
- You're risk averse but want to earn more than a savings account. If you're scared of losing money but still want some growth, CD accounts balance safety with better returns.
- You have a specific date when you need your money back. By design, CD accounts make sense for when you know exactly when you'll need the money back. For example, you're saving for a vacation in six months or retirement in three years. You can pick exactly when to get your money back plus the interest.
- You're investing for a short- to medium-term goal. CD accounts make more sense if you need your money back within a few months or years (less than five). For these short-term goals, you have less time to recover after a large loss in the stock market.
- Interest rates are high. If banks are paying higher rates than usual, you can lock in the high return for years into the future with a CD account. You'll keep earning that high rate for the entire CD term, even if market rates fall back to normal.
When investing in a CD may not make sense
- You need flexible access to your cash. If you aren't sure when you'll need your money back, a CD account might not make sense. You'd owe early withdrawal penalties for cashing out early, wiping out your return. In this case, you might be better off keeping your money in a savings account where you can withdraw at your convenience.
- You can tolerate risk and want a high return. Stocks and mutual funds don't have guaranteed returns. Your balance goes up and down, and losing money is possible. But over many years, stocks and mutual funds have historically outperformed CDs. If you can stomach short-term losses and want to grow your money as much as possible, consider market investments.
- You're investing for a long-term goal. If you're investing for a long-term goal five years away or longer, like retirement, a CD account may not be the best fit. You have enough time to wait out the stock market swings for a better long-term return.
- Interest rates are low. If market rates are lower than average, you may not want to lock up your money in a longer-term CD account. If you wait, rates could go up. You could invest then for a better deal.
Is a CD a good investment?
Yes, under the right circumstances, CD accounts can be good investments. They offer a predictable return over the term.
In general, CD accounts are a better investment if you're closer to retirement. You've built up your savings and have more of a need to protect your nest egg from a significant loss. You can use CD accounts for growth in the stretch until retirement and then for income after retirement.
CD accounts could also be a good investment if you're a younger worker with specific short-term goals, like buying a home or a car. The CD account can build up more money than a regular savings account until you reach your goal.
The roles of CDs in your portfolio
Like any investment, CD accounts have strengths and weaknesses. They offer a guaranteed return over a set period with no chance of market-based losses. In exchange, they offer less liquid access to your cash than a savings account and lower long-term returns than the stock market.
For this reason, CD accounts shouldn't take up all your money. Instead, they should be a percentage of a diversified portfolio spread across stocks, mutual funds, bonds, cash in a savings account and other assets.
Thinking about investing in a CD account? Learn more about our CD rates and terms.
