Certificates of deposit, or CDs, are popular federally insured savings accounts that traditionally have higher rates than standard savings accounts. With a certificate of deposit, you agree to allow the financial institution to hold your money for a fixed period. In return, they will pay you interest on the balance. The period is generally three months to five years. The longer you allow the financial institution to hold your money, usually the higher the amount of interest earned.
Financial institutions use CDs to acquire cash, which is later used to make loans available to individuals and businesses, hold in reserves, or spend on their operations. They may also use other funding sources as alternatives, such as the Federal Reserve Bank and other banks. These other alternatives can determine what a financial institution will set as an interest rate on a CD.
There are advantages and disadvantages to investing your money in a CD versus alternative investments. Read more below to learn about these alternative investments.
Advantages of CDs
Your funds are safe with a CD because the Federal Deposit Insurance Corporation (FDIC) insures it. The National Credit Union Association (NCUA) will protect the CD funds that are deposited into credit unions. If the financial institution fails, your money is protected up to $250,000. This makes CDs a safer option than more volatile investments, like stocks and bonds.
The interest rate earned on a CD is generally higher than what you’d find with interest-earning checking and savings accounts. Other higher-interest accounts such as money-market accounts and money market funds don't offer the same higher interest.
Terms on CDs can range widely, which make them very flexible. The term is the period the CD is held until it matures. You can find CDs ranging from three months to three years. Some people who hold CDs will create a CD ladder. This is done by taking out several CD accounts that have differing term intervals and even amounts. For instance, you might open a six month CD for $2500, a nine-month for $2500, and a 12 month for $3000. This provides more flexibility by enabling access to your cash more frequently. These CDs may be purchased at one institution or several, depending on your needs.
CDs are also a predictable source of returns. Unlike stocks or bonds, you know what to expect from your investment. They also protect you from economic changes since the interest rate is locked in for a period of time. For instance, if interest rates start to fall, your CD's interest rate won't be affected by this change through its maturity.
Disadvantages of CDs
The biggest drawback to a CD is that your money is less accessible to you if an unexpected event occurs. You'll pay an early withdrawal penalty if you withdraw the money before the CD matures. This usually comes in the form of lost interest earned or even the loss of part of your principal. The CD ladder may be a potential solution to this, so you have access to some of your cash more often. However, you might be missing out on earning higher returns since longer-term CDs typically have higher interest rate earnings.
While you enjoy the advantage of a CDs stable interest rate in a falling interest rate market, the opposite happens when they rise. You won't be able to reinvest your CD into a higher-yielding CD account until the money is available. If you have your money locked up for a year or longer, this could affect your earning capability.
Compared to stocks and bonds, CDs generally offer low returns. These high-risk, high-return investments can potentially offer double-digit returns. You'll want to consider diversifying your financial portfolio with a good mix of safe investments like CDs, and more the riskier, rewarding investment account types.
Now that you know the pros and cons of CDs, and you’re ready to open a CD account, call us. NASB offers the opportunity to discuss CD options. You can reach us at 800-677-6272. And if you would like to learn more about certificates of deposit, check out our NASB Now video series, Understanding Certificates of Deposit.