Certificate of Deposit Advantages and Disadvantages: What Is a CD?Saving Money
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A Certificate of Deposit (CD) is a type of financial instrument that has a fixed maturity date and a fixed interest rate.
It is a promissory note issued by a bank to a customer.
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What Is a Certificate of Deposit?
Another way to look at a CD is as an agreement between an individual and a credit institution, typically a commercial bank.
Depositors lend banks money and generate a return on that money.
Access to the funds is restricted until the maturity date comes to pass, until which the depositors (alternatively termed CD holders) have no access to the funds.
Early Withdrawal Penalties
Early withdrawal from the CD will trigger early withdrawal penalties.
CDs are most commonly issued by commercial banks.
The basic premise behind a CD is that the person will get a higher rate of return due to a forfeiture of liquidity.
Small CDs (<$100,000)
There are two main types of CDs.
A small CD is one taken for under $100,000.
Some of these will have minimum requirements for investment, with a possible minimum of around $1,500.
Jumbo CDs (>$100,000)
CDs that are over $100,000 are referred to as large or jumbo CDs.
Both types are flexible with regard to the terms and conditions.
CDs are insured by the Federal Deposit Insurance Corporation (FDIC) to $250,000.
The primary purpose of the FDIC is to prevent scenarios that could result in banking runs and an ensuing crisis.
Certificate of Deposit Example
An investor might like to generate a better rate of return on the $10,000 in his or her bank account than what is typically available with the standard deposit account.
A CD would be a good alternative.
In this instance, the CD could be given with an interest rate of 2.5% annually compounded, with a maturity term of 3 years.
An early withdrawal penalty of 3 months could apply.
Certificate of Deposit Earnings
By the end of the first year, the CD will have returned $250, making the total $10,250.
By the end of the second year, the CD will have returned $256, making the total $10,506.
By the end of the third year, the CD will have returned $263, making the total $10,769.
After three, years, the CD will have matured.
If the amount was withdrawn before maturity, then a fee of 3/12 of the total yearly interest rate would apply.
The early withdrawal penalties depend on the issuing institution as well as the overall length of the CD.
Certificate of Deposit Advantages
A CD is a great tool for people to earn interest on their money.
Customers simply agree not to withdraw any money from their account, and in return will gain interest.
This can be partly attributed to the fractional reserve banking model.
The more money that banks have, the more that can be lent out, and the more interest they will earn from their loans and rates.
The terms and conditions of each CD will vary, and it is difficult to lay out the exact terms.
Much will depend on the individual agreement.
The period of time with CDs can vary from 3 months to five years, depending on the specific investment goals, as well as the terms and conditions of the particular investment institution.
The longer the term of the CD, the greater the rate of return.
One of the main advantages of CDs is their flexibility.
Because of the wide variety of CD’s available, there is one to suit all investing requirements and preferences.
The interest rate on CDs is superior to the interest rate that is generated from a standard savings account.
The interest rate is higher due to the fact that the CD holder cannot withdraw funds from his or her account.
Steady Rate of Return
The CD rate will also remain constant.
This means that investors can be sure of the rate of the return regardless of what happens in the wider economy.
This makes it easier for investors in terms of financial planning.
They know exactly what they are getting and can budget accordingly.
Another benefit is that CDs are taxed on the interest earned.
Which means that it is treated as personal income, and interest is taxed at the usual rate.
Certificate of Deposit Disadvantages
Of course, with all financial products, there are both pros and cons.
The most obvious drawback to a CD is that CD holders cannot access their own funds without triggering an early withdrawal penalty.
So, the liquidity is limited.
Anything could happen, such as an accident, which would mean that the CD holder would need access to funds.
On the other hand, it might be needed for a golden business opportunity.
Having access to finance is always good for anything that could arise, positive or negative.
Early Withdrawal Penalties
CDs have a penalty on withdrawals for those who take money out, violating the terms and conditions of the agreement.
However, it is possible to take advantage of a no penalty CD, though it will likely come with a lower rate of return.
The other big disadvantage associated with a CD is that it does not pay enough to beat the rate of inflation, much like a deposit account.
In order to beat inflation, it is necessary to invest in an asset that would generate a higher rate of return, such as a stock.
But this is much riskier, as the company could go bankrupt or the stock could generate a negative return.
When Should I Get a Certificate of Deposit?
Provided you have a sum of money over $1,000 or so, there is no reason not to get a certificate of deposit.
It has a higher rate of return than a deposit account and is 100% safe due to FDIC insurance up to $250,000.
There is less risk than the vast majority of other assets, such as stocks, bonds, or commodities.
A CD Can Help You Save for a Future Event
It can help you to save for a specific event in the future.
If you already have the money for a future event in 1, 3, or 5 years’ time, then you can obtain a CD and obtain interest on the money until that date.
The only instance when you should not actually get a CD is when you need the money, due to the early withdrawal penalties.
If you have a savings account which you never use, and you never intend to withdraw from, then it makes sense to simply open a CD account.
Everything will be the same, except you will be obtaining a higher rate of return for money that is not being used anyway.
Only Get a CD if You Know You Can Hold It Until Maturity
It typically appeals to investors who have no immediate need for their funds and wish to generate a higher rate of return.
Keep in mind that with CDs, the longer the maturity rate, the higher the rate of return.
There are little requirements to obtain a CD as compared to many other financial products.
Where Can I Get a CD?
CDs are typically available from commercial banks.
Currently, one of the best CD products can be obtained from CIT Bank.
How Are CD Rates Calculated?
There is no set formula for how CD rates are calculated, as it depends on a number of factors.
The lowest rate that can be offered is set by the Federal Reserve.
However, banks can borrow from each other using the London Interbank Offer Rate (LIBOR).
CD rates have to be lower than the price that banks can offer their best and most creditworthy customers.
This is because the banks have to make a profit.
The minimum amount of interest they charge customers is known as the prime rate.
Rates paid out for CDs will need to be higher than the Federal interest rate but lower than the prime rate.
There is a wide number of alternatives to CD’s, with each alternative having distinct advantages and disadvantages.
The most common alternative to a CD is the money market account.
The money market account is similar to the CD in that it pays a higher rate of return than a typical savings account.
The money market account is FDIC insured, much like the CD.
Money market accounts tend to have more liquidity than CDs.
The account holder is allowed to take out a maximum amount at specific intervals.
On the other hand, the rate of return for money market accounts tends to be lower than CDs, though rates can vary considerably from institution to institution.
Money market mutual funds are another alternative to a CD.
They are mutual funds that invest in CDs.
The main disadvantage is that they are not FDIC insured.
Avoiding Early Withdrawal Penalties – CD Ladders
Another way to gain the benefits of a CD while mitigating the risks is to use a CD ladder.
A CD ladder is actually composed of CDs with different maturity times and dates, with a staggered approach to when finances become available.
For example, a person with $5,000 could invest in 5 CD accounts of $1,000 with different maturity dates of 12, 24, 36, 48, and 60 months.
As each CD matures, a new 60-month CD can be opened.
In this manner, the maximum rate of return from the longer CDs is begin generated, while you will always have access as funds mature, instead of being locked out of funds for 5 years.
While this might increase the complexity, it is a good form of insurance in case something comes up, and is a way of avoiding early withdrawal penalties.
A CD ladder is the best way to earn a high overall return with minimal risk.
There are no real disadvantages of CD ladders.
Using CD ladders removes the main risk associated with CDs, which is access to funds.
One of the primary disadvantages associated with CDs is the risk of inflation.
However, there are a number of products which can help to offset this risk.
Treasury Inflation Protected Securities (TIPS) are a possible defensive investment to CDs.
They are a form of treasury bond.
The principal generated from TIPS increases with inflation and decreases with deflation.
This means that in a deflationary environment, TIPS will cost money.
Combining TIPS with a CD could be a smart move.
TIPS are typically issued in 5,10, and 30-year time brackets.
However, they can be sold before maturity.
Another alternative is known as inflation linked-bonds, designed specifically to guard against inflation.
Again, money can be lost with inflation bonds in a deflationary economic environment.
However, while inflation is a commonly cited disadvantage of CDs, better CDs offer a rate of return that actually beats inflation.
Many five year CDs offer a rate of return that is above 2%.
Certificate of Deposit Pros and Cons – Summary
A Certificate of Deposit is a great way to earn a larger return on your account than is normally possible.
The only real downside is that the rate of return is generally less than inflation.
Logan is a practicing CPA and founder of Choice Tax Relief and Money Done Right. After spending nearly a decade in the corporate world helping big businesses save money, he launched his blog with the goal of helping everyday Americans earn, save, and invest more money. Learn more about Logan.