The Pros and Cons of CD Investing in 2024
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Summary:
CDs are considered a safe and reliable method to store money while earning interest. Since CDs lock money up for a period of time, they can be considered less liquid than other asset classes. However, CDs are backed by the U.S. government, so they are considered among the safest investment vehicles out there.
When investing and saving money, there is often a tradeoff between return on investment and risk profile. Investment products that offer a high return or high upside will usually carry a higher level of risk. This is why, when structuring an investment portfolio, it’s crucial to incorporate various degrees of risk, return, liquidity, and diversity. To balance the higher-risk products, investors often choose to add CDs, some of the safest and most reliable ways to invest money.
At different times in your life, you may want to invest more or less heavily in CDs in order to meet your financial goals. We’ll explore the pros and cons of CD investing so you can decide if CDs are a good option for your portfolio.
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CDs 101
Certificates of deposit accounts, or CDs, allow investors to save money for a set period of time while interest accrues. These accounts are usually offered by banks, credit unions, and other financial institutions that deal in retail or personal banking. CDs are similar to money market accounts in that they both offer higher interest rates than savings accounts. However, CDs offer even higher interest rates than money market accounts due to the lockup period.
CDs are usually insured by the FDIC (Federal Deposit Insurance Corporation) or NCUA (National Credit Union Administration), meaning that they are backed and insured by the full faith of the U.S. government. However, due to the relatively low risk, CDs historically do not have the greatest yields.
History of CDs
CDs were invented in Europe in the mid-17th century as a simple way to make a return on investment of capital. The investor would hand the merchant or financier a lump sum of say, $100. Then the merchant or financier would return the money after a fixed period with an interest payment of $10 or 10% compounded. The fixed period made sense at the time because the asset being financed consisted of voyages throughout the world. A longer fixed time period for repayment incorporated the same risk factors that are still prevalent in investing and trading.
Today, CDs work much the same way. You lock up a certain amount of money which you get back after a term of months or years with interest.
CD structures
There are different structures for CDs, which you may want to explore:
- Callable CDs can be called back by the issuing bank before the maturity date for a set price.
- Brokered CDs are outsourced to brokers to sell, and often come with higher yields than traditional CDs.
- Step-up CDs start out with one interest rate that increases every few months.
- Bump-up CDs allow you to raise your interest rate one or more times during the term.
Pros and cons of CD investing
As with any investment, there are pros and cons to consider before you invest your money.
Pros
These factors make CDs especially appealing to investors.
Safety
Perhaps the greatest attribute of CDs is their safety. You can rest easy knowing your CDs will be protected by the FDIC or a similar equivalent. Just as with a regular savings account, the FDIC will insure up to $250,000 of your CDs per financial institution. If you have $250,000 worth of CDs at Wells Fargo and another $150,000 of CDs at Bank of America, both will be insured.
Fixed returns
Investors in CDs will not have any surprises throughout the term. The CD’s issuer will give the investor a certain amount of money after a certain amount of time, guaranteed. This helps when you are building a portfolio. You want some investments that have a stable fixed return to complement more aggressive investments.
Better returns vs. a savings account
CDs offer better returns than both savings accounts and checking accounts. For individuals who have a lot of cash available, it can be a smart move to stick some of that capital in a CD for a while. Particularly in scenarios where inflationary pressure eats into the value of cash, CDs can offer a better hedge than a traditional savings account.
Diversity of structure and terms
CDs aren’t a one-size-fits-all concept only available for high-net-worth individuals with private banking access. Anyone can invest in CDs with various time frames and starting balances. For instance, there are many CD accounts that require only $500 to be locked up for six months. For others, a CD with $50,000 locked up for five years might make more sense. There is A CD to fit pretty much anyone, regardless of income level. Many people opt for a CD ladder structure, in which they save money in multiple CDs for varying amounts of time. Then they can withdraw money at different times instead of just one.
Availability
CDs are not difficult to obtain. In the United States, at least, you can walk into most Main Street banks and open one within minutes or hours. Since the FDIC backs them, banks see CDs as a mainstay that should be available to anyone.
Some CDs are more flexible than others, with a better early withdrawal penalty and interest rate risk. These banks offer CD accounts — find one that works for you.
Cons
These factors make CDs less appealing in certain circumstances.
Liquidity
Unlike other interest-bearing savings accounts like money markets, CDs are notoriously illiquid. The money needs to stay in the CD until it reaches a maturity point under the terms of the contract. You won’t be able to access the money without incurring a large financial penalty.
Pro Tip
Although CDs are illiquid by nature, they can be used to access funds if they act as a securitized asset in a loan. In short, you can put your CDs up for collateral when trying to obtain a loan. This can solve the problem for those that need quick cash but don’t want to suffer the penalties of withdrawing from a CD early.
Lower yields
There almost always exists a tradeoff between risk and reward in finance. Since CDs are so safe to invest in, the yields offered are lower than other investment vehicles with a higher risk profile, such as real estate. In a booming stock market, for instance, CDs can seem stagnant and return a much lower yield than an ETF attached to an index for the same period of time.
Early withdrawal fees and penalties
The fees involved in accessing the money in a CD before the maturity date can be substantial. For investors who have emergencies come up and need to liquefy assets into cash, withdrawing early from CDs can be a daunting move.
Taxes
CDs don’t work like Roth IRAs — the return on investment from the CD’s yield is taxable. For a product that doesn’t yield much to begin with, this can seem like a bit of stretch. This is why it’s important to choose the proper time frame and capital allocation for your portfolio.
Time vs. inflation
Long-term CDs will, in many cases, offer a higher yield than short-term CDs. However, CDs locked up for a longer period of time risk being affected by inflation, which eats into the absolute value.
So how should I invest in CDs?
CDs should not be considered an all-encompassing monetary solution for a person’s retirement goals. Rather, they should be part of a diversified portfolio that contains different time frames, capital structures, and risk allocations. CDs are considered a “risk-free” asset and thus should be allocated based on an investor’s timeline, risk appetite, and goals.
For example, a 28-year-old investing for his retirement might want to allocate 5-10% of his portfolio to low-risk investment vehicles, such as CDs or U.S. Treasury bonds, with the additional 90-95% consisting of stocks, bonds, and alternative assets. Likewise, a 50-year-old nearing retirement might want 20-30% of his portfolio shifted to CDs, with the rest of the portfolio allocated elsewhere.
FAQ
Are CDs a good thing to invest in?
CDs offer a higher annual percentage yield than a traditional savings account or money market account. However, they should only encompass part of an existing portfolio.
What is the downside to a CD?
There are several downsides to a CD, such as their lower yield relative to other investments and taxes. However, the largest downside is their relatively illiquid nature. If you have an emergency and need to access cash, it can be difficult to do without incurring a substantial early withdrawal penalty.
Are CDs safe if the market crashes?
Yes, as long as the CD is at or below $250,000 at one bank or financial institution, it is 100% safe as it’s insured by the U.S. government.
Are CDs better than stocks?
CDs are a more stable investment than stocks but they offer a lower possible return.
What is the benefit of putting money in a CD?
The benefit of putting your money into a certificate of deposit is that you know exactly how much you will earn and exactly when you will earn it. When the CD reaches its maturity date, you receive the principal plus interest earned over the term.
Key takeaways
- CDs can be a great way to safely earn interest on money by locking it up for a set period of time and waiting until the maturity date.
- CDs are insured by the FDIC, so they are considered very safe investments and are available at most banks or credit unions.
- CDs, however, are also highly illiquid and offer lower yields than more aggressive asset classes, such as stocks or real estate.
- When you get closer to retirement, you may want to invest more of your money in stable assets like CDs.
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