Certificates of deposit (CDs) are a type of savings account that allows you to earn a high fixed interest rate for locking up your funds for a set period of time.
CDs offer a safe way to invest your cash while earning more than your regular checking or savings account — some are currently paying over 4.5% APY (annual percentage yield).
But are CDs worth it?
With some account restrictions and possible penalties, CDs aren’t for everyone. We’ll cover the pros and cons of CD accounts, show you how much you can make, and also be clear on who they are not for.
How CDs Work
CDs are deposit accounts that allow you to earn interest on a set deposit amount — but you lose access to those funds for a set period. The amount of interest you can earn is typically correlated with how long your funds are locked away.
For example, a 6-month CD may pay 4.25% APY, while its 12-month counterpart could pay 4.5%. Every bank will have its own rates for different term lengths.
Once you choose a CD term and deposit your money, you can't access those funds before the end of that term without paying a penalty. Federal law requires a penalty of seven days’ simple interest if you withdraw funds within six days of deposit.
But every CD has its own penalty terms, so it’s important to read through them before making a deposit.
Once the CD matures at the end of the term, you will receive your deposit back, plus interest earned. You can choose to roll the funds into another CD or withdraw the funds.
Pros of CDs
CDs provide a way to grow your money without subjecting it to the volatility of the stock market and offer several advantages.
Risk-free returns
CDs are seen as one of the safest investments. Outside of an early withdrawal penalty, you can't lose money on a CD. Plus, your funds are protected with FDIC insurance — up to $250,000 for individual accounts and $500,000 for joint accounts.
Higher rates
CDs typically pay higher rates than other savings accounts. This is because your funds are locked up for a while and the bank can use them to offer financial products to other customers. In return, CDs are now paying over 4% APY in many cases.
Lots of term options
While CDs do lock your money away for a while, there are many term lengths to choose from. This lets you create a savings plan that works with your goals and still earns a healthy return.
CDs laddering
One strategy for maximizing CD returns is called the CD ladder. The idea is to buy multiple CDs with different term lengths to extend your returns over time. For example, you can buy 1-year, 2-year, 3-year, 4-year, and 5-year CDs, giving you access to your funds each year while earning a great return over a longer period.
Cons of CDs
While CDs are a great way to earn interest on funds you don’t need access to for a while, they also come with some drawbacks to consider.
They are less liquid
CDs pay great rates in exchange for locking your funds away. This means you can’t access your money during the term without paying a penalty. This makes them a poor place for emergency funds or other money you need access to.
Instead, use a high-yield savings account for your emergency fund.
Early withdrawal penalties
If you withdraw money from your CD, you will most likely be hit with an early withdrawal penalty. These penalties vary but usually result in losing the interest you earned.
High minimum deposits
Many CDs have a minimum deposit, with some requiring thousands of dollars to sign up. This can be a barrier if you don't have that much available money to lock away.
Returns aren’t as good as investing
While CDs offer solid returns, over the long term, investing in the stock market produces stronger returns. If the inflation rate spikes, your locked-in APY may no longer be as attractive.
RELATED: What Are Brokered CDs? How They Compare to Traditional CDs
When Are CDs Worth It?
CDs are great savings tools for future expenses that are far enough away that you won’t need access to the money in the meantime.
While CDs don’t let you add more money after you've opened one, if you already have a lump sum of money set aside, locking those funds into a CD can earn you interest while you’re waiting for an upcoming expense.
CDs can also be a great option for retirees who want a safe place to park their funds. For example, retirees who want to have a few years of cash set aside can use CDs to earn money on those funds. If they create a CD ladder, as those CDs mature, they’ll have access to the funds needed for their living expenses, while the rest of their cash is earning.
Finally, if you are simply a risk-averse investor, CDs offer virtually risk-free returns that are insured by the FDIC.
While CDs may not keep up with stock market returns over a long period, they are a viable fixed-income option and safer than bonds and other investments.
When Are CDs Not Worth It?
If you need access to your funds, CDs aren't a great option. Your funds will be locked up for months (or even years). While there are flexible CDs that allow you to withdraw without penalty, they pay a lower interest rate.
If you want to earn a higher interest rate than a regular savings account but don't want to be locked into a CD, consider a high-yield savings account. These still offer decent APYs but you have easier access to your funds.
CDs are also not a replacement for long-term investing. For a growth-oriented investment that outpaces inflation, investing in the stock market and other assets will outperform CDs.
RELATED: What To Look for When Buying Stocks
TL;DR: Is a CD a Good Investment?
CDs are a great place to park savings you don’t need access to. But their rates typically don't outperform the stock market over time, so they shouldn't be your only investment for long-term goals like retirement.
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