What Is A CD And Are They Right For You?
What Is A CD And Are They Right For You?
If you’re looking for a place to invest your money that’s less volatile than the stock market but more aggressive than a savings account, then CDs might be right for you. With that said, let’s examine a few of the pros and cons of investing in CDs and help determine if they’re right for you.
What Are CDs?
A Certificate of Deposit (CD) is an investment product that pays you interest in exchange for depositing a lump sum for a predetermined period of time. When looking at Certificates of Deposit, there are three factors that you’ll need to consider:
- The rate: The amount of interest that you will earn over the duration of the CD.
- The term: The length of time that you will need to keep your funds committed. Terms can range anywhere from 3 months to 5 years.
- The principal: The amount of money that you’ll deposit when you open the CD.
These three factors can vary widely depending on your goals as an investor as well as the options offered by the institution that you’re working with.
Pros of CDs
A few of the pros of investing in CDs include:
- Safety: Just like depositing money into a high-yield savings account, investing in CDs is incredibly safe. As opposed to buying a stock or piece of real estate, a CD is not really an investment that you’d ever expect to lose money on. On top of that, CDs are typically insured by the FDIC which adds another layer of protection to your capital.
- Fixed returns: Since the interest rate that you earn is fixed, CDs offer very predictable returns alongside the benefit of protecting your lump sum. Again, compare this to something like a stock, whose price is constantly fluctuating.
- Flexibility: CDs give you plenty of flexibility since you can choose the amount of money that you want to invest as well as how long you want to keep it invested.
- Good risk/return ratio: The rate that you can earn by investing in CDs is always fluctuating. But, considering how safe it is to invest in CDs, they still generate a fairly large return when compared to other investments like a savings account.
Cons of CDs
A few of the cons of investing in CDs include:
- Committing your capital: The main downside to using a CD is that you need to commit your capital for a specified period of time. This can range anywhere from three months to five years. Opening a CD means that you won’t be able to access your money until your term period is up without paying a penalty. Compare this to putting your money in a savings account, where you can withdraw it at any moment. Even equity investments offer more liquidity since you can sell your stocks at any moment.
- Low reward: CDs are not known for generating high returns when compared to assets like stocks or real estate. However, they are also much safer than stocks or real estate. This is why the decision of whether or not to invest in CDs depends on your financial goals and personal risk tolerance.
CD Investing Example
When you open a Certificate of Deposit, there are three factors that will influence your decision:
- How much money do I want to invest? (the principal)
- How long do I want to invest my money? (the term)
- What rate do I want to earn? (the rate)
You have control over the first two factors, but the third one will depend largely on what financial institutions are offering.
As an example, let’s say that you open a 6-month CD at a 4% interest rate. If you choose to deposit $5,000 then you will earn $200 in interest over the course of your term.
That said, you can increase the amount that you earn in interest by increasing your principal.
If you were to take the same CD but invest $10,000 instead of $5,000 then you would earn $491 in interest over the course of your term.
For most investors, the biggest downside to investing in CDs is that you cannot withdraw your money until the term date is up. If something happens and you need to access your money before the maturity date then you will be forced to pay a penalty. However, one way to mitigate this downside is to use a CD ladder. A CD ladder is a strategy that involves buying multiple CDs that have staggered maturity dates.
For example, instead of investing $10,000 into one CD with a term rate of 12 months, you could invest $2,500 in 4 different CDs with rates of 3 months, 6 months, 9 months, and 12 months. This way, a portion of your money will be freed up every 3 months. If you don’t need the money when your CDs expire then you can simply open up a new CD and keep the ladder going.
Staggering your CDs this way can help you protect your portfolio against changes in interest rates or other risks. It also allows you to take advantage of higher interest rates that are usually offered by CDs with longer maturity dates without committing all your money.
What makes CDs so safe?
We’ve mentioned a few times that one of the biggest benefits of buying CDs is how safe they are. But, what makes them such a safe investment? There are two main factors:
- Fixed-rate: With a CD, you know exactly how much interest you will be earning on your investment. On the other hand, when you invest in an asset like a stock, there is no way to know what kind of return you’ll get.
- FDIC Insured: CDs are also insured by the FDIC, which means that you can expect to get your money back if something happens to the financial institution that you invest with. However, FDIC insurance typically only covers $250,000.
Are CDs right for you?
CDs are a great investment for people with ample savings that want to generate a consistent stream of income with as little risk as possible. If you want to invest your money but are apprehensive about buying stocks, real estate, crypto, or other assets then CDs can offer a great, reliable place to get started.
A few examples of people who a CD would make sense for are:
- A retired couple that wants to keep their nest egg growing with inflation, without putting it at risk.
- Someone who’s saving for a down payment on a house and plans to buy in the next year or so.
- Anyone who is apprehensive about stocks, bonds, real estate, or other investment vehicles.
- A company with plenty of cash on hand that wants to generate a return but doesn’t want to risk losing its capital.
Finally, as a general rule, CDs are one of the safest investments out there. The only strategy that is safer is to put your money directly in savings accounts. But, on the flip side, CDs generate a return that is significantly higher than most savings accounts. The biggest downside is that you need to commit your capital for an extended period. However, you can mitigate this downside by using a CD ladder or comparable strategy.
If you feel that CDs are right for you then be sure to shop around and ensure that you are getting the best rate. Just like savings accounts, interest rates for CDs can vary widely depending on the institution that you invest with. You can start your research process by creating a Landing Rock Insured Deposit Account today to learn more!
We hope that you’ve found this article valuable when it comes to learning what a CD is and whether or not they’re right for you.
Disclosure: Insights content is not financial advice. Please be sure to do your own due diligence and speak to your financial advisor before making any investment decisions.