Certificates of deposit, also known as CDs, are a type of deposit account that many banks and credit unions offer. They provide a fixed rate of return if the funds are left in the account for a set period of time, usually anywhere from 3 months to 5 years.
CDs have long been regarded as a relatively low-risk investment option, but are they really a good choice in today’s economic environment? There are several factors to consider when deciding if CDs make sense for your investment portfolio.
What are CDs and How do They Work?
A certificate of deposit is a promissory note from a bank that they will pay you a guaranteed rate of interest for a predetermined amount of time if you put a certain amount of money on deposit with them.
Unlike a normal savings account where your money is accessible and the interest rate fluctuates, a CD locks up your money for the duration of the certificate and promises you a fixed return.
Here are some key features of how CDs work:
- Maturity Date – CDs have set maturity dates ranging from 3 months to 5 years. The money deposited cannot be withdrawn until the CD matures without facing penalties.
- Interest Rates – The annual percentage yield (APY) earned on a CD depends on the length of the maturity. Longer-term CDs generally have higher interest rates. Rates are fixed when you open the CD.
- Minimum Balance – Many CDs require a minimum deposit to open, often between $500 to $1,000.
- Early Withdrawal Penalties – If you need to withdraw funds before the maturity date, you face stiff penalties, usually equivalent to several months’ worth of interest.
- FDIC Insurance – CD balances up to $250,000 are insured by the FDIC at banks covered under the FDIC program. This makes them very low-risk.
Once a CD reaches maturity, you can withdraw the principal and interest earned or roll it over into a new CD. Overall, CDs offer a fixed return over time with very little risk as long as you don’t cash them out early.
Benefits of Investing in CDs
There are several potential benefits that make CDs an attractive investment for certain investors:
Guaranteed Returns – The interest rate earned on a CD over its term is fixed, guaranteeing a known rate of return if held to maturity. This provides peace of mind compared to variable rate investments.
Protection from Market Fluctuations – Interest rates and security prices rise and fall over time. But because the CD interest rate is fixed, there is no interest rate risk. CDs preserve capital even during stock market swings.
Low Investment Minimums – Many CDs have relatively low minimum deposit requirements ($500 to $1,000) making them accessible even to smaller investors.
FDIC Insurance – CD balances up to $250,000 are insured by the FDIC, making them very low-risk compared to many other investments.
Simple and Safe – CDs are a straightforward, predictable investment option. As long as you don’t withdraw early, you know exactly what return to expect.
Drawbacks of CD Investments
However, CDs do come with some downsides to consider:
Locking Up Funds – The biggest disadvantage of CDs is that your money is inaccessible until maturity. This lack of liquidity can be problematic if you need the funds.
Penalties for Early Withdrawal – While you can withdraw funds before maturity, the penalties can be excessive. Typically you forfeit several months’ worth of interest.
Rates May Lag Inflation – While CD rates often beat savings account rates, they may not outpace inflation which decreases your purchasing power over time.
Alternatives May Provide Higher Returns – The fixed returns of CDs cap your potential earnings. Stocks, bonds, mutual funds and real estate provide potential for higher returns.
Tying Up Money Long-Term Is Risky – With longer-term CDs, you face greater risk of lower real returns if inflation rises or interest rates increase after opening the CD.
Interest is Taxable – Unlike municipal bonds, the interest earned on CDs is subject to taxation at your ordinary income tax rate.
Current CD Rate Environment
CD rates are impacted by macroeconomic conditions and the policies set by the Federal Reserve. This can influence how attractive CD investments are at any given time.
Currently, as of October 2023, CD rates are on the rise after hitting historical lows during the past decade and a half. The Federal Reserve has been aggressively raising its benchmark interest rates in 2022 and 2023 to fight inflation. Banks have followed suit by raising the rates they offer on financial products like CDs.
1-year CD rates currently average around 3.5% APY across major financial institutions. 5-year CD rates are averaging approximately 4.25%. These rates provide yields significantly higher than the near-zero rates that prevailed from 2008 to 2021.
With inflation still running high at over 8%, CD rates still have some room to rise further. But they are providing positive real yields once again. The higher rates may attract more consumers to lock up funds in CD investments right now. However, if rapid interest rate hikes trigger an economic slowdown, the Fed could cut rates again leading to declining CD yields.
Is Now a Good Time to Invest in CDs?
So given where CD rates currently stand, is now a good time to put some money into certificates of deposit? There are arguments on both sides of the issue:
For Investing in CDs
- CD yields are the highest they have been in over a decade, far surpassing savings accounts.
- Rising rate environment means yields could climb further.
- Low risk compared to bonds/stocks in a volatile market.
- Can lock in fixed returns and avoid market timing decisions.
Against Investing in CDs
- Inflation still higher than CD rates, eroding real returns.
- Economic uncertainty may lead the Fed to reverse course and drop rates.
- Alternatives like stocks have higher upside over the long run.
- Locking money long-term limits flexibility if rates rise further.
- Long maturities have greater inflation/interest rate risk over time.
There are good reasons on both sides. An investor’s personal risk tolerance and assessment of both inflation and Fed rate policy will determine if the current environment makes locking up funds in CDs attractive. Conservative investors focused on capital preservation may find CDs alluring today. But more aggressive investors seeking higher returns may want to consider stocks, mutual funds or other assets.
Who Should Consider CDs?
While CDs may not be a good fit for every investor, there are certain individuals who might specifically benefit from putting a portion of their portfolio into certificates of deposit:
- Retirees – CDs provide fixed income at little risk, making them appropriate for portfolios focused on capital preservation and predictable cash flow.
- Conservative Investors – Those with low risk tolerance who want principal protection with guaranteed returns will appreciate CDs.
- Short-Term Savings Goals – CDs work well for money being set aside for needs 2-3 years out.
- Emergency Funds – A CD ladder strategy with maturities spaced out provides access to emergency cash while earning higher yields.
- Young Savers – Children’s savings offers a safe way to teach financial basics like earning interest and avoiding unnecessary withdrawals.
Maximizing Returns on CD Investments
While CDs may not offer the highest investment returns, there are strategies to optimize the interest earned:
- Compare CD rates across banks and credit unions to find the best APY.
- Consider longer maturities (1-5 years) to get the highest rates.
- Set up a CD ladder with multiple CDs maturing in a sequence to gain liquidity.
- Look for special brokered CD deals that offer higher yields.
- Research promotional “bonus APY” CDs that offer a few months of extra interest.
- Avoid early withdrawals that will cut into your gains.
- Hold CDs in IRAs/401ks to get tax deferred growth.
The FDIC provides a helpful CD interest calculator that allows you to compare national average rates and projected earnings based on deposit amount, compounding frequency, and term length. This can help investors identify the best CDs.
The Bottom Line – Who Should Invest in CDs?
CDs can play a valuable role in a balanced investment portfolio for certain investors, especially retirees, conservative savers, and those with short-term savings goals under 5 years. In the current rising rate environment, CDs offer relatively safe returns that surpass savings accounts and money market yields.
However, locking money up long-term in CDs can be risky if interest rates continue to climb or inflation persists. And more aggressive investors may prefer allocating funds to mutual funds, stocks, or real estate for higher growth potential.
Ultimately, your personal financial situation, savings objectives, timeline, and risk tolerance will determine whether certificates of deposit are a smart investment choice right now. If safety and predictability are your top priorities, CDs may have a place in your portfolio.