Certificates of Deposit (CDs): Benefits & Drawbacks

CDs are like a piggy bank with interest that you can't break until a certain amount of time has passed.

A certificate of deposit, or CD, is an investment vehicle that is offered by banks, thrift institutions and credit unions. CDs function like a savings account, however, each CD has a maturity rate in the length of a number of months. Each month that your money is in the CD it gathers interest. At the end of the maturity date you have access to your money and the interest it has earned. CDs offer a higher rate of interest than a typical savings account, but they require a higher balance and there is a penalty in the form of a fee for withdrawing your money before the CD matures.

The Pros of CDs

Unlike many other investments, certificates of deposit are completely safe, as long as you have them with an FDIC-insured bank or NCUA-insured credit unions. You can visit the official website of the FDIC or NCUA to check for the name of your institution. If the institution is insured, should anything happen to the principal amount of your deposit it will be reimbursed to you up to $100,000. Only invest the maximum amount of money the FDIC insures per CD, per bank. In times of economic instability, the FDIC insurance will mitigate any risk you take on in the stock market or any other volatile type of investment. The rate of return on CDs is higher than savings accounts and depending on the institution that you're banking with, it could be higher than other banks. Smaller banks tend to offer higher rates than bigger banks. CDs are a great option to save up for things like purchasing a car, a vacation, or other costly items.

Cons of CDs

The rate of return on a CD may not be worth it when the inflation rate is factored in. If the inflation rate happens to be higher than what your rate of return is then you are losing the purchasing power of your money. Regardless of how much you have you will be able to buy less with it. The inflation rate can effectively cancel out the interest earned on the CD in terms of the goods and services you are able to buy. If this is the case you may as well keep your money in a savings account, where you can withdraw the money at your will without a penalty, which is another con. The liquidity of a CD is very low. The set period of time (maturity) can range from 18 to 60 months and can be a hindrance if you need to withdraw your money before the CD matures. The penalty is usually reliquinshing a number of months of interest.

Cons Continued

The lower return rate of CDs can be affected by inflation, but it can also be canceled out by the average rate of return in a stable stock market, which is 10 percent. The average CD return is 3 percent to 5 percent. You may be able to get a higher rate of return from an institution that is not FDIC insured, but you are taking on a higher risk and forgoing the main benefit of a CD, which is that your principal balance is always safe and will never diminish.