Certificate of Deposit Pros and Cons
August 24, 2023
A certificate of deposit (CD) is one type of savings account for long and short-term savings. Since a CD usually offers a higher interest rate than traditional savings accounts, it may seem to be the better choice for any saving goal, from a short-term goal like an Indianapolis vacation or a longer-term retirement goal.
However, it has some drawbacks that may make the other savings accounts the better choice in some cases. We will help you determine whether a certificate of deposit is your best saving option by covering the certificate of deposit pros and cons.
What is a Certificate of Deposit?
A certificate of deposit is a type of bank account that pays you interest in exchange for holding your money over a set period. Although it is a savings option, a CD differs from a traditional savings account in several ways. The primary difference is that you won't have free access to your deposited funds as with other savings accounts.
How Does a Certificate of Deposit Work?
Before opening a CD account, you must select the time (CD term) that you agree to store your money in a CD. Banks or credit unions can offer CD terms from 28 days to over ten years. Although some banks offer promotional CDs with high-interest rates and shorter terms, most CDs offer higher interest rates for longer time commitments.
Most CDs have a fixed annual percentage rate (APY). This rate type means your interest earnings will not change during the entire CD term unless you have a bump-up CD. A bump-up or set-up CD allows you to increase your rate once or twice during the life of the CD. Once the CD term ends, you can withdraw the money you've saved and the earned interest. Or you can roll over your savings and interest earnings into a new CD account. Some banks do this process automatically.
Pros of a CD
A CD has several attractive benefits and features worth considering when choosing a savings plan. These four pros are the most significant.
High Interest Rate and APY
A CD's most obvious advantage over traditional savings accounts is it typically offers a higher interest rate and annual percentage yield than a savings account. Banks and other financial institutions use the higher interest payout the make the CD savings option more attractive.
If you buy your CD account through an FDIC-insured bank, the Federal government insures your deposit up to $250,000. Credit Unions can insure CD deposits through the National Credit Union Association (NCUA). For this reason, CD accounts are just as safe as savings or money market accounts for saving money for retirement in Fort Wayne or whatever you desire.
Most CD accounts have fixed interest rates throughout the complete term. As a result, you can easily calculate the amount of interest the CD pays you over time. This benefit is favorable if you want to avoid riskier options while making a decent return on your money. You can confidently plan to earn X interest on your deposit in X number of years without losing a penny of your initial deposit.
Unlike savings accounts, CD accounts are usually free of monthly maintenance fees. This benefit means that fee deductions will not reduce your interest earnings. Also, if you don't withdraw money before the CD maturity date, you can build your savings without an extra cost to factor in.
Cons of a CD
Although CDs offer exceptional saving benefits, some limitations may cause you to consider the other accounts more.
Lack of Access to Funds
Certificates of deposits are more valuable to banks because money in a CD account is a more stable source of funds for investment and lending. So, when you agree to lock up your money for a set term, you trade your ability to easily withdraw money from your CD before the maturity date in exchange for higher earnings. This condition can be a problem if you believe you will need the money before the end of the term.
Interest Rate Risk
Your CD interest rate and APY offer will depend on the current market interest rate. As a result, any significant upward or downward movement in the market interest rate affects your CD's value and interest earnings. It doesn't matter whether you have a fixed or variable interest rate — you face interest rate risk by saving through a CD.
If your CD has a variable interest rate, it will usually yield a higher return when market interest rates are high. But if the interest rate drops, your CD will typically experience low growth. On the other hand, a CD with a fixed rate loses value when interest rates go up. The locked-in status of your CD money makes it very difficult and costly to move it into an account with a higher interest rate.
Early Withdrawal Penalties
Banks structure CDs to hold the money you intend to store away for a while. Although it's not forbidden to withdraw funds before the maturity date, banks and credit unions typically charge an early withdrawal penalty fee. The penalty can be a flat fee or a percentage of the interest earned. Some financial institutions keep all the interest earned through the CD, sending a strong message not to break the deal.
You may prefer saving your money on a safe CD over a higher risk, higher earning potential saving option. However, depositing your money in a CD exposes you to inflation risk. This means the prices of goods and services can rise so high that they exceed the rate of return of your CD earnings. If the market interest rate is extremely low, your earnings may not qualify as a cost-of-living adjustment.
Who Should Consider a CD?
A certificate of deposit is a better fit for people looking for a savings option with the highest predictable return at the lowest risk. But they should be willing to do so without using the deposited money until maturity.
How to Get a Certificate of Deposit
You can open a certificate of deposit the same way you open other savings accounts. Just visit the bank, credit union, or online financial institution of your choice and complete a few steps before depositing your money. However, the most vital part is finding the best CD options available.
Making the Best Saving Decision for You
CDs offer a happy medium between risk and return if you can make a few concessions. With all the institutions providing CD accounts, it helps to do business with a bank you can trust to give you a solid advantage. If you live in South Bend, Michigan City, Gary, or any other Indiana city, discover Centier Bank's CD options by visiting our website.