Certificates of deposit, more commonly known as CDs, have been a long-time staple in financial portfolios. A CD is a contract between a bank and an investor where the investor agrees to deposit money into their account for a set period of time in exchange for a fixed interest rate. The longer you agree to preserve your money in the account, the more you’ll make in interest. Depending on the bank, the term length of a certificate can range from a few months up to several years. With your commitment, you are promising to keep all money and interest in the account for the agreed period of the contract.
The Appeal of CDs
The biggest appeal of financing through CDs is the comfort and security this type of investment offers. Whether the financial market is at a high or a low or somewhere in between, your money is going to be safe. CDs are low-risk funds since their interest rates are locked in and they are insured by the Federal Deposit Insurance Corporation (FDIC) for up to $250,000. So, your principal is always secure. Having this assurance, you can more accurately predict your earnings and more readily plan for your future. (For more, see: CDs vs. Inflation: Are They Keeping Up?)
Interest rates provided through CDs are higher than the interest yielded in other protected investments such as savings accounts and money market funds. Smaller banks and online banks typically provide the best rates for CDs. Smaller banks need your business, so they are more willing to offer higher interest rates. Online organizations have less operational costs allowing them to extend more profitable percentages.
Drawbacks of CDs
When you invest through a CD, your money is unavailable for the set term of the certificate. This is a major disadvantage of investing in CDs. Unless you select a no penalty CD, which is typically less profitable, there is a stiff penalty for those who choose to withdraw money before the CD matures.
While fixed interest rates provide security with your investment, there are drawbacks to this feature. Since CDs have fixed interest rates, they do not increase with inflation. So, you could lose the chance to participate in a more lucrative investment while your money is tied up in a CD.
During years past, returns offered through CDs were profitable. However, times have changed and CD rates have dropped to a high of 2.5%. Typically, CD rates are much lower than the high. As this decline is expected to continue, CD profits won’t be able to keep up with inflation rates. Even if you are ultra conservative in your investments, CDs are still not a smart option for your money. There are a variety of possibilities out there that can easily outperform a 2.5% return.
If you are a conservative investor and looking to finance without withdrawal penalties, a money market account is worth considering. Money market accounts are FDIC insured and similar to savings accounts in that you can easily open an account and start depositing money. Money market returns are usually less profitable than CDs, but you have the flexibility to withdraw funds with no cost. So, if interest rates rise, you can take advantage of the hike since you are not locked into a fixed rate. The down side of money markets is that banks often apply more restrictions on these accounts. This can result in higher opening balance requirements and limited withdrawal privileges. (For more, see: How to Create a Laddered CD Portfolio.)
High-Yield Savings Account
While traditional savings accounts provide little interest, there are high-yield savings accounts available at some financial institutions. These accounts are fully protected by the FDIC up to $250,000, and you can access your cash without penalty. However, high-yield savings accounts have drawbacks too. Many of these accounts are only available online making access to your money more limiting. There are also fees to consider and minimum deposits that may be required with these type of accounts.
Peer-to-peer lending (P2P) is an investment option that began in 2006. It is slowly gaining popularity. This innovative practice pairs individuals who want to borrow with investors who want to lend money without the assistance of a bank. Since the intermediary is removed, investors receive higher rates on the interest they accrue as compared to investments available through a bank. With the benefit of a higher return, P2P consequently encompasses more risk, time, and effort. While the P2P industry follows collection procedures when borrowers fail to pay back their debt, these loans are less secure overall and can result in a substantial loss for investors.
Historically, investing in bonds is a conservative way to benefit from stable income on an investment. When you purchase a bond, you’re basically becoming a lender to the government or a business. Generally returning at a rate of 3% to 5%, bonds lean toward higher dividends than savings accounts or money market accounts. Even though bonds offer more stability than stock investments, there is a higher risk with bonds today as recent government policies are quickly advancing inflation. This can lead to a decline in profits and lower principal values.
Mutual funds have been a common vehicle for investing for years. Mutual funds involve a collection of different shares of individual stocks or bonds. Typically, mutual funds are specially selected by a financial advisor or financial team. Unlike individual stocks, the price of a mutual fund does not fluctuate during the trading day as it is established at the day’s end. There are costs to consider with mutual funds including administration fees, commissions and other expenses. On average, mutual fund expenses vary from 0.1% to 3% annually. These fees are not always obvious and can be a detriment to your overall profit.
The Stock Market
Stock market investments are much riskier than CDs, but also have the possibility of much more profit. Since the beginning of 2009, the S&P 500 has gone up by over 200%. While the result of this increase has been lucrative for many, we don’t know how long this rise in the stock market will continue.
There are pros and cons to each type of investment you consider. In determining what’s best for you and your situation, it is vital you take into account many variables. This includes your income level, financial goals, age and risk tolerance. The financial market continues to grow and develop. It’s important to be in the know, so you can make sound and profitable financial decisions. (For more from this author, see: Why You Should Start Financial Planning Early.)