Advantages & Disadvantages of a Certificate of Deposit

by Michael Keenan
Banks offer CDs to fund their loan products.

If you're looking for a higher rate of return than a savings account but don't want the risk of loss that investing in stocks brings, a certificate of deposit might be for you. However, CDs aren't without their disadvantages, and if you think you might need the money, they can be a costly investment.

Money Locked In

A certificate of deposit requires that you keep the money in the account for a specified amount of time before it matures. If you take out money early, you'll usually owe a penalty, which can vary widely. For example, on a one-year CD, penalties ranged from 30 days of interest to $25 plus 3 percent of principal, per Bankrate.com. However, this disadvantage may be mitigated if your particular CD allows you to withdraw a certain amount penalty-free.

Higher Rates Than Savings

To get customers to put money in CDs, banks often offer higher rates for certificates of deposit than for savings accounts. For example, as of October 2012, one-year CD rates are about three times higher than savings accounts, with the CDs yielding 0.29 percent and savings accounts yielding 0.1 percent. Jumbo CDs, generally meaning CDs with $100,000 or more, offer even higher rates.

Rate Locked In

CDs often have a set interest rate for the term of the CD, which can be either an advantage or disadvantage, depending on whether interest rates go up or down. If interest rates rise, it's bad because you're stuck with a lower rate. However, if interest rates fall, you're locked into a higher interest rate. However, some CDs allow you to bump up your interest rate during the term so you can take advantage of rising rates, and others offer variable rates that change as the market changes.

Security

CDs are covered by the Federal Deposit Insurance Corporation. This insurance protects your money, up to the annual limits, in the event that the bank goes under. As of 2012, your deposits up to $250,000 per bank are covered, so if you have $200,000 in CDs at one bank and $230,000 at another, your entire $460,000 is covered.

About the Author

Mark Kennan is a writer based in the Kansas City area, specializing in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."

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