The Weaknesses & Strengths of a Certificate of Deposit

A CD pays guaranteed interest.

A CD pays guaranteed interest.

When you hear the term "CD”, your thoughts may turn to your favorite music album or an old collection of compact disks rather than financial products. In personal finance, “CD” stands for "certificate of deposit," which is a type of interest-bearing account that you can open at banks that behaves similarly to a traditional savings account. CDs offer can offer higher interest rates than normal savings accounts, but they are not without their drawbacks.

Your Money is Safe

One of the primary benefits of putting money in a certificate of deposit at a reputable bank is that you won't lose money. When you invest in assets like stocks, mutual funds and real estate, the value of your investment can go up and down with demand, so you might lose money. Similar to savings account, a CD is just a container for your money that earns a fixed interest rate: the amount of your initial balance cannot go down. In addition, certificate of deposit accounts are eligible for federal deposit insurance for balances up to $250,000. Even if your bank goes up in flames or is the victim of a massive heist, the government will give you your money back if the bank can't come up with the cash.

You Earn Modest Returns

CDs typically offer higher interest rates than standard savings accounts, which make them preferable to savings accounts if you don't plan to use your cash and you simply want to earn guaranteed interest. On the other hand, the return on a CD is modest compared to the returns that are possible on more risky investments like stocks and mutual funds. While stock prices can go up and down, the market tends to trend up as a whole over long periods of time, so if you plan to put money away for retirement, stocks can be preferable to CDs.

You Have Limited Access to Cash Your

Certificate of deposit accounts come with preset maturity date that can be anywhere from a few months to several years after the date that you open the account. If you try to withdraw your money before the maturity date, the bank may impose a penalty, such as forfeiting any accrued interest. In other words, once you put your money into a CD, you usually can't get the money out before the maturity date without a slap on the wrist. If you might need your money before the maturity date on a CD, a normal savings account is a better option.

Inflation Can Eat Gains

Inflation is like a beast lurking in wait to gobble up the gains you earn on fixed interest accounts. Inflation is the rate at which prices increase over time. For every percentage point of inflation, the effective return on a CD goes down by one. For example, if a CD earns 4 percent a year in interest but the inflation rate is 3 percent, your purchasing power — the amount of stuff you can actually buy — only goes up by 1 percent a year.

About the Author

Gregory Hamel has been a writer since September 2008 and has also authored three novels. He has a Bachelor of Arts in economics from St. Olaf College. Hamel maintains a blog focused on massive open online courses and computer programming.

Photo Credits

  • Hemera Technologies/PhotoObjects.net/Getty Images