Certificates of deposits are a popular investment avenue for people looking for a steady and secure investment with minimal risk. In this blog post, we will explore various advantages and disadvantages of a certificate of deposit, its meaning, and how it works.
What is a Certificate of Deposit?
A certificate of deposit is a type of savings account issued by banks and credit unions. When you invest in a certificate of deposit, you loan your capital to the bank for a fixed duration. The bank offers you an interest payment for your investment.
The term duration for CD can range from 6 months to 5 years. Banks or credit unions offer higher interest rates for long-term deposits when compared to regular savings accounts.
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How Do CDs Work?
Certificate of Deposits works on a simple principle: you invest a certain amount in the bank, and they pay you interest for your contribution. Here’s a step-by-step breakdown of how CDs work:
1. Choose a Term-Length
The first step for any investor is to select a term length per their investment goals. CDs offer a term of 6 months, 1 year, 2 years, or 5 years. You can choose your term length after evaluating the advantages and disadvantages of a certificate of deposit for all terms.
2. Deposit Fund
Once you have carefully evaluated the advantages and disadvantages of a certificate of deposit for each term length, it’s time to deposit your funds into the CD account. This amount is called the principal account.
3. Interest Accrual
Once you have invested the principal amount, the bank will pay you a fixed interest rate annually or at the end of the term.
4. Maturity
When your investment reaches its maturity date, you can withdraw your principal amount with the accrued interest. Another option at maturity is to roll over the previously matured CD into a new term.
Considerations Before Investing in CDs
Before you decide whether to invest in CDs, read this blog post completely to understand all of the advantages and disadvantages of a certificate of deposit. Here are some things to consider before you invest:
1. Early Withdrawal Penalties
One of the major disadvantages of investing in a CD is the penalty it incurs if the investors try to withdraw the amount before maturity. If someone were to withdraw the amount before maturity, it would not only penalize them but also reduce or eliminate the interest accrued on the investment.
2. Inflation Risk
As an investor, inflation plays a huge role when you consider the advantages and disadvantages of a certificate of deposit. If you are trying to keep your investment up with inflation, there is a major risk while investing in CDs. CDs offer a fixed interest rate, which means no matter what the market condition is, it won’t change.
Such a sturdy interest rate can be beneficial or unfavourable to investors, depending on the conditions. High inflation in the market can result in lower purchasing power. Meanwhile, low inflation means higher purchasing power for investors.
3. Opportunity Cost
Investing in a Certificate of Deposit requires a huge commitment in terms of money. While investing in CDs, you are locking your principal amount for a long time and cannot withdraw it without incurring a penalty. This means you cannot invest in other opportunities that come after investing.
It’s important you consider this factor: can you commit to investing for the long term?
Advantages of Certificates of Deposit
1. Safety and Security
When discussing various advantages and disadvantages of a certificate of deposit, it is considered one of the safest investment options.
They are secured and insured by the Federal Deposit Insurance Corporation (FDIC) for upto $250,000. Being insured means even if the bank is on the verge of collapse, your investment will be secured upto the limit.
Additionally, one of the advantages of depositing in a CD is that you can never lose your principal amount. These factors make it a safe option for conservative investors or retirement planners.
2. Fixed Returns
When we discuss various advantages and disadvantages of a certificate of deposit, it is vital to consider the interest rate. CDs offer a fixed interest rate throughout the agreed-upon term.
A fixed interest rate on your principal amount ensures you get a 100% profit on your investment. A fixed interest rate is especially beneficial if the market inflation falls.
3. Higher Interest Rates
When considering the various advantages and disadvantages of a certificate of deposit, its interest rate is far more beneficial than other savings accounts. CDs have a higher interest rate when compared to traditional savings accounts. It also offers more attractive returns in the long term than a savings account.
As an investor, you can use a laddering strategy for CDs. A laddering strategy involves buying multiple CDs with different maturity dates. With multiple CDs, you can have several long-term and short-term CDs. This strategy provides more liquidity with the same interest rate benefit than having one CD for the long term.
4. No Maintenance Fees
While discussing the advantages and disadvantages of a certificate of deposit, it is crucial to consider the maintenance fees. Unlike a savings account, CDs do not incur any maintenance fees, making them more attractive and a better option than a savings account.
Disadvantages of Certificates of Deposit
1. Lack of Liquidity
When pondering the various advantages and disadvantages of a certificate of deposit, the most vital disadvantage of CDs is their lack of liquidity.
Once you have invested in a CD, you cannot withdraw it without incurring a penalty. Along with the penalty, it can also minimize or eliminate the interest that was generated on the amount.
Additionally, a lack of liquidity can also affect your personal finances. The invested amount is locked in, making it impossible to withdraw without loss, making you immobile in case of an emergency.
2. Inflation Risk
Higher inflation poses a solid threat to your investment. If the inflation rate exceeds your interest rate, your future amount will be negative. Thus, while offering security and stability, CDs can be a double-edged sword if inflation rises.
3. Opportunity Cost
While we discuss the various advantages and disadvantages of a certificate of deposit, it is essential to keep in mind that there are numerous investment opportunities that have the potential to offer better returns.
When we deposit our money in a CD, it gets locked in, making it immobile. Once locked, you cannot invest the capital elsewhere later, even if the other option provides much better returns.
In a situation where inflation rises, other investment options, such as real estate or bonds, also follow suit and increase their value, old CDs become obsolete. With locked capital, you cannot even purchase a new CD with a better interest rate at such times.
4. Complex Terms and Conditions
While learning about the numerous advantages and disadvantages of a certificate of deposit, we must consider the Terms & Conditions associated with CDs.
Investments have complex Terms & Conditions to protect the investor and the issuer, and CDs are no different. They come with a comprehensive set of Terms & Conditions, such as compounding frequency, penalties for early withdrawal, and automatic renewal policies. As an investor, you must read these details to be entirely aware of your actions.
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FAQs
What are the advantages and disadvantages of a certificate of deposit?
The advantages of CDs are that they are FDIC-insured, have predictable income, and have a higher rate of return than savings accounts. The disadvantages of CDs are that they have limited liquidity because of early withdrawal penalties and the potential for returns to lag behind inflation.
What are the benefits of a certificate of deposit?
Certificates of Deposits offer higher returns than traditional savings accounts; they are FDIC-insured and have a predictable future return. Along with these, CDs have zero maintenance charges, which eliminates extra charges.
What are the disadvantages of CDs?
The disadvantages of certificate of deposits are lack of liquidity due to early withdrawal charges and higher inflation, which can result in negative future income. Additionally, CDs lock your investment amount, making it immobile, so you cannot invest it in other options.
Are bank CDs risk-free?
Certificates of Deposits are secured and insured by the Federal Deposit Insurance Corporation (FDIC) for upto $250,000. Even with this, they are still subject to inflation and incur early withdrawal penalties.
Final Statement
After thoughtful consideration and careful review of all the advantages and disadvantages of a certificate of deposit, we can say that certificates of deposit offer a safe and risk-free way to grow your capital, an excellent option for risk-avoiding investors. However, they come with certain disadvantages, including limited liquidity, inflation risk, opportunity cost, and complex terms.
Before investing in a CD, it’s crucial to weigh the advantages and disadvantages of a certificate of deposit in light of your financial goals, risk tolerance, and the current economic environment.
I hope this post exploring the advantages and disadvantages of a certificate of deposit was informative. Let us know your doubts and questions in the comment box.