A Certificate of Deposit (CD) is a safe way to invest your money if you don’t plan on needing it for a long time and don’t mind earning only low interest rates. A CD is a safe, straightforward, and not particularly exciting method of saving money. Think of a CD as the financial equivalent of a seat belt: You wear it for safety and protection, but you wouldn’t brag about it to your friends.
Also, if your goal is to retire on a beach and drink piña coladas while watching the sunset, using a CD as your primary investment vehicle for building long-term wealth. A CD will not give you a large amount of growth; it will simply sit there for an extended period of time while inflation takes its toll on your purchasing ability.
So why do banks bother to offer CDs? To answer this question, we must first consider how a CD works. Then, we will ask an unasked yet important question that every bank should answer from the outset: why does a bank want you to deposit your money in a CD for several years?
It’s quite simple—banks are in the business of making money by lending out money. The most significant factor contributing to a bank’s ability to make more loans and earn interest is the amount of money deposited by customers and how long they will be able to keep that money deposited without withdrawing it. When customers decide to open a CD with a bank, banks see this as a great opportunity to loan out more money because they do not have to worry about customers withdrawing the money on short notice.
Customers will benefit from having their money deposited in a bank for a longer period of time due to slightly better interest rates than those found on traditional savings accounts. This is an opportunity for both the bank and customers to benefit from the financial relationship—though customers will not experience the large returns that they would experience if they invested in other products.
A CD is Like a Savings Account That Charges You a Ransom Every Time You Try to Withdraw Your Money.
For the most part, when you open a CD, you will have a fixed interest rate that will be paid to you on a monthly basis. The term that you choose determines how long you agree to keep your money with the bank and will usually take anywhere from 28 days to 10 years to mature, after which you can withdraw your money. The longer the term you select and the more money you deposit, the higher the interest rate that you can expect to receive, but the fact remains that compared to traditional savings accounts, the interest rates on CDs are not much higher than those of traditional savings accounts.
Understanding Interest Calculations
Many individuals may view how interest works when investing in CDs (Certificates of Deposit), and assume that when they see a CD rate of “2%” that they would automatically receive this amount of money immediately. This is untrue; the 2% rate on a CD is an annual rate.
An example is:
- $1,000 deposited into a 1-year CD earning 2% interest would receive $20 in profit (after one year).
- $1,000 deposited into a 6-month CD earning 2% interest would receive $10 in profit (after six months).
- $1,000 deposited into a 3-year CD earning 2% interest would receive $60 in profit (in total over the three years).
In other words, the interest paid on CDs follows the same principle as how time passes—interest is calculated throughout the term of the CD.
Penalty Upon Early Withdrawal
If you have to withdraw your money from your CD before the end of the term, there may be penalties involved. Most banks will penalize a customer for early withdrawal of funds. Normally the penalties include a reduction in principal or interest or both. For example, some banks may deduct 1% of the principal amount of the CD. Other banks may deduct several months of interest from the prior balance when you withdraw funds. Still, other banks may choose to write off everything you have earned up to this date.
Having to pay for a meal after breaking up with a partner.
Reasons to Invest in CDs
Despite these penalties and the hassles involved, many investors continue to use CDs due to two reasons.
- CDs are virtually risk-free.
- CDs are insured by FDIC (for banks) or NCUA (for credit unions), protecting your investment unless the universe collapses around us.
The predictability of Fixed-Term Investment Options (CDs)
The type of fixed-return investment known as a Certificate of Deposit (CD) will provide a known amount of income and certainty in income based on the time period of the CD. When you Invest in a Certificate of Deposit (CD) you Invest with confidence that the money will grow as stated without being affected by unpredictable short-term fluctuations in the marketplace.
So if you prefer having a predictable outcome with no unexpected surprises you can Rest Easy Knowing that your Investment in a CD is going to continue growing until the expiration of the CD or at the time you decide to withdraw the money.
When Saving for a Down Payment on A Home
Let’s say you and your spouse have been saving $25,000 for the down payment on a home and will not be ready to purchase the home for seven months because your rental agreement is still in effect. This situation is perfect for an Investment in a CD.
By Investing your $25,000 into a six-month CD, you’re able to earn more interest than if you put that money into a traditional savings account. Since you won’t be accessing that cash during the term of your CD, you may as well use that time to earn interest on it and allow that cash to work for you for a Short Term.
The true value of a CD is for short-term Investment with no risk for your cash until the expiration of the CD Term.
Putting Your Emergency Fund into A CD
Here is the grey area when you think about putting your emergency fund into a CD. You need to understand that an emergency can occur at any given moment and your CD may not be mature when your emergency takes place. Therefore, you Will have a problem accessing your cash and may also be subject to Penalties or Fees when you withdraw the funds.
If impulse purchases are a problem for you, then a Certificate of Deposit (CD) serves as a type of “self-control lock” for your bank account. The fact that CD accounts penalizes you if you withdraw your money early, creates a barrier in your mind for buying things you don’t need.
A CD may be a good solution if you understand how you spend.
CDs vs. Investments
If you are saving for retirement and wish to grow your investment over the long term (40-50 years), then a CD is not a wise choice. A CD may provide a small amount of interest over that period of time, which may not keep up with the inflation rate; therefore, you would be losing money on your CD after paying taxes on the interest (if any).
Stocks and bonds, however, generally provide a much higher rate of return on investment compared to CDs; although they are also riskier investments.
Low risk, low reward. High risk, high reward. This is the most basic rule of investing.
Certificates of deposit (CDs) are straightforward, secure, and often wise investments, but they lack excitement compared to other options. CDs can be beneficial or detrimental; rather, they function as tools, much like a hammer for instance, that may be perfect for a specific project at one moment and ineffective for another project at another time.
When considering your goals for investment, if you want to achieve:
- Short-Term Gain
- Zero Risk
- Predictable Returns
And You Know You Won’t Need the Money
Then Using a CD As Your Investment May Be Ideal For You.
On The Other Hand, If You Desire:
- Long-Term Growth
- Return Above Inflation
- Wealth Accumulation
Then Using a CD As Your Investment Is Equivalent To Taking A Nap.
