Advantages and Disadvantages of a Certificate of Deposit
Besides savings accounts, another way of earning interest from financial institutions is by starting a Certificate of Deposit (CD). When money is deposited into an account at a financial institution, it becomes a part of the total deposits. These funds can now be used to lend to other customers/members. One of the ways by which financial institutions overcome this issue is by offering a CD. A CD is an agreement between the customer/member and the financial institution that the customer will not withdraw any cash within a fixed period in return for a higher rate of interest on those funds. The period in which the depositor is not allowed to withdraw cash varies depending on the terms of the CD. The terms can be as short as three months and as long as five years. Generally speaking, the longer the terms of a CD, the higher the interest rate.
Though CD’s are considered to be a solid investment tool, just like any other investment, CD’s also have their own strengths and weaknesses that should be considered.
The following are a list of advantages and disadvantages of a CD to consider:
Advantages
- Flexible Terms: The terms and the amounts that can be deposited into a CD are flexible. If you are not willing to tie up your money for a long time, you can easily opt for a shorter term CD. At the end of a CD term, you can renew that CD or start a new one.
- Safety: CD’s that are available from a federally insured institution are generally insured up to $250,000. This takes much of the risk out of the investment.
- Better Return Than Saving Accounts: Since the CD holder is not allowed to withdraw money freely like savings account holders, CD’s are more valuable to the financial institution. For this reason, the interest rate offered to CD holders is higher than a traditional savings account.
- Wide Selection: You can get CD’s of various maturities and terms from different banks and credit unions. Because of the diversity of CD’s, investors can find a CD that meets their individual needs.
- Fixed, Predictable Return: The investor can be sure about getting a specific yield at a specific time. Even if the interest rates come down to a broader economy, the CD rate will remain constant. You will be able to easily determine the rate at which your balance will grow, thus making financial planning easier.
Disadvantages
- Limited Liquidity: The owner of a CD cannot access their money as easily as a traditional savings account. To withdrawal money from a CD before the end of the term requires that a penalty has to be paid. This penalty can be in the form of lost interest or a principal penalty. To increase flexibility, the investor can create a CD Ladder, which is composed of CD’s with different maturity dates and terms. With a laddering strategy, you have more options to access your CD savings at different intervals of time.
- Inflation Risk: CD rates may be lower than the rate of inflation. This means that your money may lose its purchasing power over time if interest gains are outdone by inflation rates.
With these advantages and disadvantages in mind, it is wise to consider that CD advantages usually outweigh the disadvantages. CD’s allow you to grow your savings without hassle. You can easily compare different types of CD’s with the help of online resources, and you can find one that best suits your needs.
