If you have some spare cash to save or invest, there are many options open to you. Two of these are a certificate of deposit (CD) or investing in an exchange-traded fund (ETF). At first glance, both investments appear to offer similar advantages to investors—both are often presented as relatively low-risk ways of putting money aside for the future, and earning a modest return in the interim.
In reality, there are some important differences between CDs and ETFs. One of these is the level of risk you are exposed to. With a CD, you will earn a guaranteed return. Though ETFs are safer than investing in individual stocks, they are still traded on the stock market and are vulnerable to fluctuations in the price of assets. This makes ETFs riskier than CDs, especially over the short term. On the other hand, ETFs can be more flexible than CDs and offer higher returns over the long term.
In this article, we’ll look at the key differences between CDs and ETFs, so you can choose the investment that is right for you.
- Though both CDs and ETFs appear to offer a low-risk, low-cost way to invest your money, there are important differences between them.
- CDs are low-risk, short-term, low-return investments that are best suited for people looking to save money in the short term or those who want to avoid any kind of risk.
- ETFs, in comparison, offers both higher risk and (potentially) higher returns for long-term investors who can ride out price fluctuations.
- If you want to save for retirement, ETFs will be the best pick here. If you want to buy a boat in a few years, but have the money now, use a CD.
CDs vs. ETFs: The Key Differences
To understand the differences between CDs and ETFs, it’s worth reviewing the definition of both.
A CD is a financial product offered by a bank. When you take out a CD, you agree to leave your money in one place for a set period. In exchange, your bank or credit union will pay you a set interest rate on this money; one that is typically higher than other types of savings accounts. The downside is that your money isn’t liquid—you have to leave it in the CD for the whole term you’ve agreed to or you’ll have to pay hefty penalties.
An exchange-traded fund (ETF) is a type of pooled investment security that operates much like a mutual fund. Typically, ETFs will track a particular index, sector, commodity, or other assets, but unlike mutual funds, ETFs can be purchased or sold on a stock exchange the same way that a regular stock can. An ETF can be structured to track anything from the price of an individual commodity to a large and diverse collection of securities. ETFs can even be structured to track specific investment strategies.
ETFs are popular investments for people looking for relatively low-risk, low-cost investments. They offer exposure to the stock market, but most are inherently well-diversified. This means they can offer higher rates of return than a CD. However, investors should remember that investing in an ETF is still investing in volatile assets and so is inherently risky.
CDs work differently—the bank or credit union that holds your CD guarantees you a set return, no matter what happens to the stock market. They are, in other words, very low risk. This aspect makes CDs suitable for very risk-averse investors or those looking to meet specific financial goals. CDs are good for people who have some spare cash that they don’t need right now but will need in a few years.
Let’s look at these differences in more detail.
CDs are some of the safest investments available, because you get a guaranteed interest rate, no matter what happens to the stock market. Though there is a risk to the bank with CDs—if there is a huge stock market crash, they might lose a lot of money—you are protected from this risk. In addition, the funds you put in your CD account are covered by Federal Deposit Insurance Corporation (FDIC).
Most ETFs try to mitigate risk differently—through diversification. ETFs have historically been designed to track a particular index or sector and have been passively managed to make sure that they track their associated index closely. This makes them far less risky than investing in individual stocks. But it doesn’t eliminate the risk.
CD investments are also protected by the same federal insurance that covers all deposit products. The FDIC provides insurance for banks and the National Credit Union Administration (NCUA) provides insurance for credit unions. When you open a CD with an FDIC- or NCUA-insured institution, up to $250,000 of your funds on deposit with that institution are protected by the U.S. government if that institution were to fail. In contrast, funds invested in ETFs are not protected at all.
In other words, ETFs are relatively low risk in comparison to other ways of putting your money into the stock market, but CDs come with virtually no risk at all. This makes CDs suitable for people looking to invest over the short term, where stock market fluctuations could affect the price of a stock portfolio or ETF, or long-term investors who just don’t trust the stock market and want to be as risk-free as possible.
Ideal Length of Investment
The risk of a given investment is related to the length of time you hold it. Well-diversified stock portfolios and ETFs are regarded as relatively low-risk over the long term because the stock market tends to increase in value. However, if you are only looking to invest for a few years, a stock market crash (or even a drop in a particular sector of the economy) can easily wipe out the value of your investment. This makes ETFs a relatively risky choice for short-term investment.
In contrast, CDs are good for short- to medium-term investments: investments lasting one to five years. But once again, there is nothing wrong with using CDs as a long-term investment tool if you want to build a very low-risk portfolio—you might just have to put up with low returns.
Make sure you understand the early withdrawal penalties that apply to your CD account. If you need to access your money in an emergency, you could have to pay hefty fees.
There are two main downsides to CDs. One is that they are very inflexible investment vehicles. You have to leave your money in the CD for the term you’ve agreed to (unless you have a liquid CD, no-penalty CD, or some other exotic type). Otherwise, you’ll probably have to pay sizable early withdrawal penalties that could wipe out your returns.
In contrast, ETFs are relatively flexible. You can buy and sell shares in ETFs as often as you like, and cash them out whenever you like. You may have to pay a fee for doing so, but it’s generally less than the penalties associated with early withdrawals from CDs.
This flexibility might be attractive if you need to access the money you’ve invested in an emergency. But keep in mind the point above—that if you put your money into ETFs, you can lose money as well as make it. You can pull your money out of the ETF at any time, but there is no guarantee that you won’t have lost money since you bought into it, especially if that was quite recently.
Another downside to CDs is their relatively low returns. This is a feature they share with other types of low-risk investments. Because the bank guarantees that they will pay you a particular interest rate, they don’t want to make this too high. If they do, and they can’t generate that level of return by investing your money in other ways, they will lose money.
Of course, the rate of return offered by ETFs can be quite variable and not guaranteed in any way. Even a low-risk fund might lose much of its value over a few weeks and an economic crisis could adversely affect the value of your shares in the fund for a decade or more. But over several decades, the returns offered by a well-diversified stock portfolio are expected to exceed those of CDs.
Frequently Asked Questions
Are CDs Better Than ETFs?
It depends. CDs are great for people looking to invest their money for a few years or build very low-risk portfolios. In general, though, investing in an ETF will offer higher returns in the long run.
Are CDs Safer Than ETFs?
Yes, much safer. When you take out a CD, the bank or credit union will guarantee your interest rate, making CDs a very low-risk investment. In addition, your funds are federally insured should your bank or credit union fail. In contrast, there is no guarantee that an ETF will increase in value over time and your money is not federally protected.
Can CDs Decrease in Value?
It’s very unlikely. Nearly every financial institution offers CDs as an option and, like other banking deposits, the Federal Deposit Insurance Corporation (FDIC) insures standard CDs should the bank fail. Therefore, CDs are among the lowest-risk investments and do not lose value.
The Bottom Line
Though both CDs and ETFs appear to offer a low-risk, low-cost way to invest your money, there are important differences between them.
CDs are low-risk, short-term, low-return investments that are best suited for people looking to save money over the short term or those who want to avoid any kind of risk. ETFs, in comparison, offers both higher risk and (potentially) higher returns for long-term investors who can ride out price fluctuations. If you want to save for retirement, ETFs will be the best pick here. If you will need the funds in a few years, but have the money to invest now, a CD would likely be a better choice.