Pros and Cons of CD Investing

Talia Lee-
June 25, 2024

Investing isn’t limited to stocks, bonds, and other financial securities traded in public markets. You can also earn money with minimal risk through certificate of deposit (CD) investing.

While CDs may not be the most thrilling investment option, their safety and predictability make them appealing. Whether you’re a risky investor or a conservative one, consider incorporating CD investing into your portfolio.

CDs from federally insured banks and credit unions are secured by the full faith and credit of the U.S. government, up to $250,000 per depositor, per insured bank, per ownership category.

“The return of your money is more important than the return on your money,” says Buz Livingston, a certified financial planner at Livingston Financial Planning in Santa Rosa Beach, Florida.

The Federal Deposit Insurance Corporation (FDIC), the independent government agency that protects bank deposits, assures that no one has ever lost a single cent invested in its backed CDs. Even if a financial institution closes, your money remains safe up to the insured limit.

Because CD account holders can’t withdraw their money on demand like savings account holders can, CDs are more valuable to banks than savings deposits. Consequently, banks often offer higher yields to CD investors in exchange for locking up their money for a set term.

With the Federal Reserve maintaining its key borrowing benchmark at the range of 5.25-5.50 percent, investing in CDs remains appealing. The best one-year CDs offer slightly higher returns than the best savings accounts, making locking in a competitive rate with a CD a potentially smart financial move.

Unlike other types of deposit accounts or investments, fixed-rate CDs guarantee a specific yield at a specific time.

Even if interest rates drop significantly in the broader economy, a fixed-rate CD’s APY will stay the same for the entire term. This guaranteed rate of return allows you to easily calculate the amount of interest you will earn by the end of the term, which can be beneficial for assessing your financial plan.

CDs are offered with various maturities and yields by numerous banks and credit unions. These options include terms ranging from as short as one month to as long as 10 years or more. This variety allows investors to select a CD that matches their specific requirements.

While top CD APYs reached their peak toward the end of 2023, competitive APYs can still be found. Savers who invest in CDs now, particularly by creating a CD ladder, can benefit from these attractive yields.

Investors exploring CDs have access to various CD types tailored to different needs. For instance, some banks provide no-penalty (or liquid) CDs, which offer a competitive interest rate and the flexibility to close the account without facing early withdrawal penalties if necessary.

Additionally, there are step-up and bump-up CDs, jumbo CDs designed for large deposits, and add-on CDs that allow multiple deposits over time. These options cater to different financial goals, ensuring there’s a CD type suitable for various short-term financial strategies.

A CD ladder involves opening multiple CDs simultaneously with varying maturity dates. For example, if you have $5,000, you can distribute it across several CDs as follows:

  • $1,000 in a six-month CD
  • $1,000 in a one-year CD
  • $1,000 in an 18-month CD
  • $1,000 in a two-year CD
  • $1,000 in a three-year CD

When each CD matures, you can reinvest the funds into a new CD. It’s not necessary to allocate equal amounts to each CD, especially if shorter-term CDs offer higher Annual Percentage Yields (APY) compared to longer-term ones. Additionally, you can diversify across different financial institutions based on the CDs offering the highest APY and with the fewest eligibility requirements and fees.

One significant drawback of CDs is their lack of flexibility when it comes to accessing funds unexpectedly. Withdrawals before the CD’s maturity typically incur penalties, which can erode interest earnings and potentially even diminish the principal invested.

“Liquidity is often crucial during uncertain times. It can be used for seizing buying opportunities in a volatile market or for covering essential expenses without the need to liquidate long-term investments,” explains Alex Reffett, principal and co-founder of East Paces Group in Atlanta.

While CDs offer a reliable way to earn interest on idle cash, consumers should carefully consider CD yields and terms in light of their potential liquidity needs.

To enhance flexibility, CD investors can implement a CD ladder strategy with CDs of varying maturities. This approach ensures that portions of their CD savings become available at regular intervals.

For instance, you could construct a CD ladder with three tiers: six months, one year, and two years. Shorter-term CDs provide access to funds sooner, allowing you to capitalize on future higher rates, while longer-term CDs offer the opportunity to lock in current higher yields.

“When you lock your money into fixed-rate CDs, there’s a risk that your purchasing power could erode over time if your interest earnings fail to keep pace with inflation,” explains Michael Foguth, founder of Foguth Financial Group in Brighton, Michigan.

“While CDs often offer more favorable yields compared to other liquid bank accounts, their returns are typically lower than higher-risk assets like stocks and ETFs, posing an opportunity risk,” explains Lamar Brabham, CEO and founder of the Noel Taylor Agency in North Myrtle Beach, South Carolina. “If a promising opportunity arises and your money is tied up in a CD, you could miss out.”

Looking at historical CD interest rates over the past three decades reveals their fluctuations. In the mid-1980s, five-year CDs yielded over 11 percent. More recently, rates declined significantly during the COVID-19 pandemic but saw a notable increase from 2021 to 2023 due to aggressive Federal Reserve rate hikes.

CD rates can vary widely among banks, so it’s beneficial for investors to shop around. Currently, the average five-year CD yields 1.43 percent APY, while the best rates can be three times higher than that.

When an investor locks in a CD rate, there’s a risk that when the CD matures, the yields may have decreased. If the investor chooses to reinvest, they could end up with a lower APY, a situation known as reinvestment risk.

To mitigate reinvestment risk, one strategy is to create a CD ladder with varying maturities, focusing on shorter terms. This approach enables investors to capitalize on higher rates as their shorter-term CDs mature.

Another drawback for CD investors is the taxation of accrued interest, which can reduce overall yield and potentially create cash flow mismatches.

Being mindful of the tax implications on your savings allows you to plan accordingly and make necessary adjustments.

For individuals uncertain about stock market investments or seeking to diversify their portfolio, CD investing could be a prudent choice. A CD or CD ladder can provide stability, particularly appealing to those looking to steer clear of market volatility. Conservative investors, prioritizing capital preservation over higher risks and potential losses, may find CDs appealing. Given current higher CD rates compared to previous years, seizing the opportunity to lock in these rates before any potential decline might also be advantageous.

Consider both the advantages and disadvantages of CDs if you seek a secure option for storing your funds, and compare the CD rates offered by various institutions.

Despite economic fluctuations in the U.S., avoid making decisions based solely on fear or anxiety when contemplating CD investments. Instead, evaluate your time horizon (when you anticipate needing the CD funds) and align your financial objectives and plans to determine if a CD aligns with your overall strategy.

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