Certificates of Deposits (CDs) are instruments that allow the investor to buy a certificate for a specified price, usually between $500 and $10,000, on which he or she will earn an interest rate. At the end of the term, the investor will receive the money back plus the interest earned. Below are some of the advantages and disadvantages to owning a CD.
Advantages
- Higher Interest Rate
CDs offer much higher interest rates than regular savings accounts. While most savings accounts are now earning between 0.10 percent and 0.20 percent, the short term CDs with the lowest interest rates are earning between 0.20 percent and 0.50 percent.
- Flexible Durations
There are several different term lengths for CDs, which help the investor hedge against the risk of increases in the interest rate while they are locked into a lower rate CD. Many banks offer 3 month, 6 month, 10 month, and 12 month CDs, even all the way up to 60 month and 72 month CDs.
- Forces You To Save
If you have trouble saving money, a CD can be an effective way to prevent any unnecessary spending. Since certificates of deposit can’t be touched during the term agreement, so you won’t have any choice but to leave the money alone and let it grow.
Disadvantages
- Inaccessible Money
Investing in a CD means that you give your money to the bank and you are no longer able to use it at all for the duration of the contract, unlike a savings account that you can easily deposit and withdraw money from regularly. Therefore, you can’t access the money if an occasion arises in which you need to use money in the CD.
- Locked-In Interest Rate
The buyer of the CD takes on the risk that interest rates may rise during their term, which means they are losing out on that extra interest. Traditionally, interest rates are locked in at the rate you receive when you sign for the CD. There are some exceptions to this rule, however. Some banks and institutions have certain CDs that allow the investor to “refinance” their CD once a year; meaning that if the interest rate rose in the second half of the term, then the investor could change to that higher rate and earn more return on their CD.
- Increased Taxes
You are earning more interest on a CD than with a savings account, but that also means that you will owe more taxes at the end of the year, since interest on savings tools and dividends on investments are taxable income.
Certificates of Deposit can be great tools for those who wants to make a little bit more interest in exchange for having their money stuck in a bank or financial institution, but you need to be careful that you are taking the illiquidity and inability to change the interest rate into consideration before you sign on the dotted line.
