A certificate of deposit is like a savings account with an added bonus — you agree to leave your money in the bank for a set period of time (typically between six months and five years) and in return, you'll get a higher interest rate than what you would get from just leaving it in a regular savings account.
Generally speaking, the longer you leave your money in the bank, the higher interest rate you will receive. This can work out well if you won't need your money for something specific within that time frame and want to make sure it will earn some extra return while it sits there.
However, whenever I give advice on where to store your savings, I generally don't recommend certificates of deposit. Here's why.
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1. It's a bad time for inflation and interest rates
A certificate of deposit may initially appear attractive with its guaranteed fixed interest rate, but right now, most CDs come with interest rates that are lower than the current rate of inflation. In other words, if you put your savings into a certificate of deposit, your money may be worth less in real terms by the end of the certificate's term. This makes it an unfavorable choice for current-day investors, as it would incur more losses rather than making profits over time.
What's more, if interest rates continue to rise, you'll be unable to take advantage of them once you're locked into a CD.
While there are typically no fees associated with these kinds of deposits, and the principal is safeguarded from any market losses, such a low yield won't do much for your portfolio in the long run. Other options — like utilizing mutual funds or even common stocks — can provide higher returns than a certificate of deposit.
2. Early withdrawal penalties can eat into your returns
Certificates of deposit typically have early withdrawal penalties, which can eat into your earnings if you need to access your money before the maturity date. Generally, the amount of the penalty is based on how long you have held the CD — the longer you've had your CD, the greater the penalty will usually be. For example, if you withdraw funds from a CD that has been open for one year or less, you could be liable for either 90 days' worth of interest or all of the interest that has accumulated in the CD up to that point.
If we've learned anything over the past few years, it's that the future is unpredictable. It may not be the smartest decision to lock away your savings in case an unexpected emergency were to happen. As a financial planner, I believe there are better options in terms of where to invest your money and make sure that you can access it quickly without facing penalties.
3. Better alternatives exist
As a financial planner, I always recommend exploring all available options before investing your money. Instead of locking up your money in a CD, consider other methods that produce higher returns and carry less risk.
A certificate of deposit is a low-risk way to save your financial resources — like other bank accounts, CDs have federal deposit insurance for up to $250,000, which means your money is pretty safe. However, in exchange for this safety, CDs come with much lower returns than other investment vehicles.
If you're looking to store your emergency savings somewhere, a high-yield savings account is a great way to get slightly better returns with generally very little risk. Of course, for those willing to take on more risk and accept the volatile nature of stock and bonds, these too can be reliable investments over the long haul. Taking the time to explore all your options will help you make an informed decision on the best possible way to invest your money.
Hanna Horvath is a CERTIFIED FINANCIAL PLANNER™ and personal finance reporter based in New York City. Her work has appeared in Policygenius, NBC News, MSN, Inc Magazine and more.
