One of the ways that many people choose to save money is with the help of certificates of deposit (CDs). This is because Certificate of Deposits are cash products that often offer higher yields than savings accounts. For those interested in capital preservation, with a little bit of growth, CDs can be quite helpful. A CD is a deposit that you make, but it is more than just a savings account. Here are some of the main characteristics of CDs:
- Specific term: You agree to keep your money in the financial institution for a set period of time. Most CD products are between three months and five years, but it is possible to find CDs with shorter or longer terms.
- Set interest rate: While you can find CDs with variable rates, most CDs have a set interest rate, so you earn the same amount of interest throughout the term of your CD. So in order to maximize your return you should find the best certificate of deposit rate at the time of deposit.
- Penalties: Since you are getting a fixed rate of return, and one that is higher than some other cash products, you are charged a penalty if you withdraw your cash before the expiration of the term. There are penalty free CDs, but they are few and far between.
The main advantage of a CD is that you can grow your cash a little faster, while preserving it. You can also set up CD ladders that allow you roll over your CDs in such a manner that you can have regular access to your money while still earning a higher rate of return. Other ways to earn interest is by investing in a high-yield savings account.
Drawbacks to CDs
In addition to the possibility of penalties, there are some other drawbacks to having CDs. While they are safe, as long as they are with a bank that is FDIC insured, that safety comes with a price. Here are some of the drawbacks to CDs:
- Low interest compared to other investments: CDs will not offer the same return as some stocks, bonds and other investments. If you are looking to grow your money faster, CDs may not work as well.
- Miss out on higher CD rates: Since you have to lock in a yield when you open a CD, you might miss out on higher rates if they rise after you open the CD.
- Might not beat inflation: Because the yield on CDs is often low, you might not beat inflation. If you assume that inflation is 3% to 4% a year, and your yield is only 2%, you are actually losing money in real terms.
- No FDIC Protection: Sometimes banks pay higher interest rates because their CDs are not insured by FDIC.
A CD can be a good part of your financial plan and your savings efforts. Just make sure you understand the terms, and how a CD fits into your overall financial plan.