One investment option that you might consider for an emergency fund or for the fixed-income portion of your portfolio is a certificate of deposit also known as a CD. Many people like CDs as an investment because they are secure and have a guaranteed rate of return. On the other hand, CDs are not a perfect investment option. Here are some reasons why you should and shouldn’t consider investing in a CD.
Let’s first look at the advantages of investing in CDs.
Pros
CDs are FDIC-Insured
CDs are insured up to $250,000 in losses just like your bank account deposits. Unlike stock and bond investments that can lose value when market conditions deteriorate, CDs are considered a safe investment, relatively speaking.
A CD Offers Fixed Rates of Return
With a CD, you know how much you will earn the moment you invest. You will earn a fixed amount of interest each month until the CD matures. The terms on a CD are more predictable, allowing you to lend money to the bank for a predetermined term with a fixed annual percentage yield.
CDs Offer Flexible Terms
Many banks offer CDs that mature within three months to five years. This flexibility makes financial planning easier. You can invest in short-term CDs if you have a short-term financial plan, or you can rely on more distant maturity dates for funds you might not plan to touch until retirement.
A CD Offers Higher Interest Rates Than Savings Accounts
With CDs, the bank knows you are committing your investment for a specific number of months. As an added incentive, banks offer higher interest rates on most CDs compared to a typical savings account where you can withdraw all your funds in an instant. CDs are a great way to increase your passive income because your money earns more interest compared to a traditional savings account. CDs can also have better interest rates than money market accounts and U.S. Treasury bills.
Now, let’s see why a CD is not always the best investment option.
Cons:
Early Withdrawal Penalties
If you decide to cash out your CD before it matures, you will pay an early withdrawal penalty. For instance, if you invest $500 and withdraw the money in one month, you might only get $400 back.
This is why it’s so important to only invest money in CDs that you do not plan on touching before maturity. If you think you’ll face trouble sooner rather than later, then you might consider investing in a three-year CD instead of a five-year CD for example.
If you need to withdraw early, you can forfeit any earned interest or even lose money if the earned interest hasn’t offset the early withdrawal penalty yet. Only investing a portion of your emergency savings or investment portfolio will help ensure you have enough liquid assets.
CDs Don’t Outpace Inflation
Despite having a higher interest rate than a traditional bank account, CD interest rates still lag inflation in most instances. If you want to outpace inflation, you will need to consider more aggressive investments like stocks and bonds that have historically higher rates of return.
Since certificates of deposit don’t outpace inflation, they should only be a primary investment option once you retire. Before retirement, they should only be used to reduce the investment volatility of your portfolio and to increase the earning potential of your cash savings.
Some High-Yield Bank Accounts have Higher Rates
Nearly every bank offers CDs, but not every CD investment has the same interest rate. Some high-yield online savings accounts have better interest rates than CDs. This is especially true for CDs with maturity dates of less than one year.
Putting your money in one of these high-yield savings accounts not only pays more interest, but, you don’t have to pay any early withdrawal penalties if you an unforeseen expense pops up. Before investing in the first CD you come across, do your research and compare all your banking and CD investment options.
Existing CD Interest Rates Don’t Increase with New CD Rates
If new CD interest rates increase, your existing CD rates won’t because they are a fixed interest rate. This is one downside to fixed income rates when you want to maximize your passive income.
There are several strategies to help increase your earning potential. Holding a combination of short-term and long-term CDs can help increase the odds of being able to capitalize on increasing interest rates or locking in a higher interest rate for several years before future CD yields lower.
Summary
CDs can be a good investment tool for any investor. While young investors won’t make a fortune from CDs, they do provide a higher rate of return for their savings. Older investors will appreciate CDs for their stability and the higher rate of return compared to other fixed income vehicles.
Josh Wilson recently started up his own blog, Family Faith Finance. Since then, he has been looking for writing opportunities to introduce a new, unique perspective on the world of personal finance.
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