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Pros and Cons of Investing in a Certificate of Deposit

Investing in a certificate of deposit can be safer than other financial options, but it will lock your money for a certain period of time. Here is a comprehensive list of pros and cons of investing in a CD.
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Pros and cons of investing in a certificate of deposit
Tip
In order to combat the rigidity of CDs, invest in a CD ladder comprising many CDs which will mature at different due dates, thus, providing liquidity on your invested amount from time to time.
Certificates of deposit (CDs) are savings certificates or promissory notes issued by a bank or credit union to individuals who keep their money with the financial institution for a certain period and acquire interest against it. The term of a CD can vary between 6 months to 5 years. But before you decide to invest, you must know about the advantages and disadvantages of investing in certificate of deposit. CDs are the best risk-free investment that can help stabilize your diversified portfolio. There is a risk involved in market-linked CDs as they speculate with the market, but they too have a minimum guarantee on the return.

However, remember that your money will be locked-in till the maturity date, and early withdrawals will attract a heavy penalty. Also, investment in CDs is not tax-free, and you will have to pay tax on the interest accrued. Here is a list of pros and cons of investing in a certificate of deposit that will give you more information about this investment tool.

Pros

Risk-free Investment
If you have invested in a CD, you definitely do not have to spend sleepless nights worrying about its safety. Any issues or problems with the bank will not affect your deposit. This is because all CDs, up to an amount of USD 250,000, are FDIC insured. Also, credit unions who give CDs may be NCUA-insured. Hence, rest assured as your principal amount will always remain safe. As compared to the speculation and risk involved with investments like mutual funds and annuities, CDs are definitely dependable investments.

Fixed Rate of Interest
CDs are low risk, yet moderately yielding investments. The terms and rate of your CD for the term will be mentioned on the documents. Hence, you really don't have to worry about market or economy fluctuations as you will get a specific rate of return, as decided. Hence, one tends to earn better interest on a CD than what you would on a savings deposit, treasury bills or on bonds. Moreover, this kind of steadiness is definitely comforting for an investor especially when the economy is not looking good.

Several Options
There are several banks and credit unions which offer different types of CDs with varying maturity dates and interest. Different types of CDs like traditional, bump-up, liquid, zero-coupon, market-linked, brokerage, callable, etc., exist for you to choose from. They also come with fixed or variable interest rates and can be either for long-term or short-term. You can easily compare the rates and terms of different CDs online. Hence, conduct some research, and you will definitely get a CD that caters to your requirements.

No Brokerage Fees
You do not need a broker or middleman to conduct transactions for you, thus, you save on paying for such services. All you need to do is compare the various CDs available, and find an option that will work for you. You can approach a bank or credit union directly to make the payment. Just imagine, how much money you will save in terms of brokerage.

Low Minimum Requirement
You don't need a lot of cash before you avail a certificate of deposit. Many banks have lower minimum investment requirements, which are easily affordable. Some banks offer CDs for as little as USD 500 to USD 1000, which is a negligible amount as an investment. Some banks do not even exercise the minimum amount requirement option. You can also transfer your money from your savings account into a CD. This enables low-, medium-, and high-income individuals to easily invest in CDs.

Reinvestment is Easier
CDs accord a certain flexibility in reinvestment. You can direct the bank to credit the amount of the principal as well as interest directly to your account. You can then roll over this money in any other type of investment or in a CD again.

Cons

Inflation-sensitive Investment
Have you considered how badly inflation affects the rate of return on the CD. Remember, if the rate of inflation is higher than that of the rate of return of the CD, the value of the money earned will diminish drastically. You will lose out on purchasing power, and there will be very few things that you will be able to buy with the interest earned.

Higher Penalties
If you are planning to withdraw your money before the CD matures, think again. You may end up losing significant amount of interest earned. CDs lack any kind of liquidity. For a CD of 5 years, you may end up losing as much as 6 months of interest. Hence, unless you are in urgent need of money, or want to invest it in a higher paying investment, don't even think about withdrawing your CD before maturity. Compared to a CD, one would any day prefer to deposit money in a savings account where one has easy access to the money.

Nominal Interest Rates
CDs, though a risk-free investment as the principal amount remains safe, do not fetch an impressive rate of return. As the risk is lower, so is the yield. On an average, the rate of interest of CDs is anywhere between 2 to 5%. Locking your money away for 5 years only to earn 5% of interest may not work well for you in the long run. Another downside being the fact that a fixed rate may not allow you to reap the benefits of favorable market conditions where there is scope for the rates to rise further.

Higher Taxes
The interest earned on the CD is treated as a purchaser income. The IRS treats all your earned income to be taxable. Hence, you will have to pay taxes on the interest accrued. Suppose you own market-linked CDs, the interest you earn will compel you to pay more taxes. This will be around 15% more than what you would have to pay on capital gains earned from investing in long-term stocks.

CD Rollover Option
There are many banks who will not send you a notice before your CD matures. In fact, they will only mention a grace period before automatically rolling over the CD to a new maturity date. There are banks which do this at the original or even lower rates, and you lose out on the benefit of the renewed rate of interest.

Try to invest in CDs for a longer period to reap the benefits of a good interest rate. Before you opt for a CD, ensure that you know about the penalties. If you do not want to invest in high-risk, high-return investment vehicles, CDs are a safe bet. Just ensure that the institution offering you the CD is FDIC insured. Now that you are aware about the advantages and disadvantages of investing in certificates of deposit, invest your money wisely.
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Published: January 24, 2014
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