Regardless of your financial goals, saving money is critical. You can tuck away money in a savings account and earn interest very slowly, or you can take a chance and invest in the stock market.
But if you are looking for a risk-free way to build up your savings, you may wonder, “What is a certificate deposit (CD) account and is it right for me?” Keep reading to learn more about CD accounts and what they can do for you.
Table of Contents
How do CDs work?
A certificate of deposit account is a savings product offered by banks and credit unions. With a CD, you will deposit a lump sum amount into your account and agree to leave it there for a certain period of time.
Additionally, the return on a CD is higher than that of a savings account. But to get a higher rate, you must be willing to leave your funds untouched. If you do not adhere to this requirement, you will have to pay an early withdrawal penalty if you take your money out prior to the end of the term.
Your CD will mature at the end of the fixed period. On the maturity date, you will receive your initial deposit plus the interest that you have earned. Once it matures, you can roll all of your funds into a new bank CD or take the money and invest it elsewhere.
CDs can be safer than investing in stocks. Although CD returns are modest, you will not risk the possibility of losing the value of your investment.
Plus, if you purchase a CD from either an FDIC – or NCUA-insured bank or credit union, your deposit will be secured up to $250,000. In other words, if your bank shuts its doors, you will not lose your deposit.
Example of a CD
Suppose you invest $5,000 in a CD with a fixed rate of 2% and a one-year maturity term. At the end of the term, you can expect a return of $100 on your deposit.
Here’s how your return is calculated:
$5,000 x 2% = $100
Advantages of CDs
CDs are a useful way to save money and focus on your financial goals. In addition to being safe and risk-free, CDs have plenty of other attractive features that make them a viable investment option, including high interest rates, guaranteed returns and fixed returns.
High interest rates
CDs pay higher interest rates than traditional savings accounts. In exchange for giving up instant access to your money, you will receive a higher rate. CDs have terms that range anywhere from three months to five years, and the longer the term, the better the rate.
Unlike stocks and bonds, CDs are not affected by market risk and volatility. So, you do not need to worry about losing your investments in the market. Instead, the fixed interest rate on CDs can guarantee a return on your deposit.
CD interest rates are locked, meaning the bank cannot drop your interest rate later and reduce your earnings. With fixed yields, you always have a clear and predictable return on your deposit as well.
Disadvantages of CDs
While CDs produce guaranteed returns, there are drawbacks to consider before investing your funds in a CD account.
Little to no flexibility
With a CD, you must keep your lump-sum deposit intact. But if you need access to your cash before the end of the term, you will incur an early withdrawal penalty. Before opening a CD account, ensure that you can get by without needing to withdraw your money before maturity.
Some banks automatically renew CDs at the point of maturity. Make sure you fully understand the terms of your CD investment so that you are not locked in for longer than you want to be.
Interest rates typically rise during periods of inflation. While the locked rates of CDs can protect your earnings when rates fall, it can work against you when interest rates increase. If inflation bumps up interest rates, you could end up earning less on your CD funds as a result of being locked into the rate.
CDs vs savings accounts
CDs are a safe way to put money aside. By making one lump deposit and leaving it in your account until the term is up, your money earns a higher interest rate than it would in a traditional savings account or money market account.
Since the rate is locked, you will receive a fixed return on your deposit. If having easy access to your funds makes it hard to save money, the early withdrawal penalty may deter you from unnecessarily dipping into your account.
With a savings account, you have easier access to your funds. You can make additional deposits and withdraw up to six times per month without facing any penalties. In exchange for this flexibility, savings accounts have lower interest rates.
Are CDs worth it?
CDs are popular because of their guaranteed returns and minimal risks. They also pay more in terms of interest rates than a traditional savings account does.
While the returns are modest compared to stocks or other investments, you do not have the market volatility to contend with. You will not receive the highest returns by investing in CDs despite fixed and guaranteed returns.
If your goal is building long-term wealth, you may want to consider leaning towards stocks or mutual funds for more growth. And if you cannot hold your CD investments until the fixed expiry date, the early withdrawal penalty will reduce your cash earnings, so keep this in mind.
Invest in a certificate deposit account
A certificate of deposit account is a reasonably safe way to grow your money. With fixed rates and guaranteed returns, your funds should grow at a predictable rate each year. And since you cannot touch your deposit until maturity without incurring a penalty, CDs can help you stay on track when it comes to saving money.
Are CDs a good investment in 2022?
If you are looking for a safe and risk-free way to invest your money in 2022, CDs may be a good option for you. CDs have the potential to offer a better return in 2022 as rates continue to rise as well.
Will bank CD rates rise in 2022?
CD rates are influenced by the federal funds rate. As the federal funds rate continues to rise in 2022, bank CD rates are expected to rise as well.
Do you pay taxes on a CD?
You will pay taxes on the interest you have earned from CDs. The taxes you will pay are based on the year in which you earned interest.