Advantages & Disadvantages of a Certificate of Deposit

Advantages & Disadvantages of a Certificate of Deposit
••• John Foxx/Stockbyte/Getty Images

Want a safe way to grow your money gently? You might consider a certificate of deposit from a bank or credit union. Unlike stock investing, which can be volatile, a CD locks away your money for a fixed period and with a fixed interest rate. Your returns won’t set the world on fire, but it’s just about the safest investment you can make.

Risk-Free Investment Option

There are plenty of reasons why you might want a CD. The main one is safety. A CD works just like a regular savings account; only you promise to leave the money untouched for a certain period. Terms range from one month to around 10 years.

When the time is up, and the CD matures, you get all your money back plus the interest you were promised – guaranteed. That means literally guaranteed by the Federal Deposit Insurance Corporation, who will back your deposit up to $250,000. You can rest easy knowing that with a CD, you’re never going to lose a single cent of the amount you invested.

Better Rates than Saving Accounts

In return for locking down your cash, the bank typically will offer a more favorable interest rate than you’d get with a regular checking or savings account. For instance, as of September 2020, Synchrony Bank is offering a 0.90 percent annual percentage yield (APY) for a five-year CD versus 0.75 percent APY for a high-yield savings account.

Relatively Liquid Asset 

CDs essentially are just cash in a bank account, which means they are a fairly liquid asset. If you need the money in a hurry, you can access it straight away. Yes, you might face a penalty (more on that below), but the money will be there when you need it as instant cash. Selling stocks and bonds is nowhere near as easy – you would need to find a willing buyer and could potentially lose a lot of money if you needed to sell your stock when the price was lower than when you bought it.

Early Access Penalties

The whole point of a CD is that you lock your money down for a set period, and typically you’ll face a penalty if you withdraw the money before its term is up. Generally, you can expect to lose a few months’ worth of interest, but you may lose a percentage of the principal, too. For this reason, a CD may not be the best place to house your emergency savings, as you need penalty-free access to this cash if an unexpected bill comes up.

Minimum Deposit Amounts

To get the best rates for your CD, you may need to deposit more than you were expecting. For instance, in September 2020, Discover is offering 0.60 percent APY for a one-year CD, which is much higher than what other banks are offering for the same CD term. But that rate comes with a $2,500 minimum deposit. For accounts with no minimum deposit requirements, you may be looking at rates that are not much higher than a regular savings account.

Low Overall Returns

Perhaps the biggest snag with CDs is that you'll only get a limited return on your investment. Suppose you’re looking to invest $5,000 in a three-year CD paying 1.25 percent interest APY. Once that CD matures, you’ll receive $5,189.85. If, on the other hand, you were to put the $5,000 into stocks, you might score roughly a 7 percent average annual return on your investment, which would leave you with $6,125.22 when those three years are up.