Certificates of Deposit Explained With Pros and Cons

Should You Buy Certificates of Deposit or Invest in Money Markets?

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A certificate of deposit is an agreement to deposit money for a fixed period with a bank that will pay you interest. You can choose to invest for three months, six months, one year, or five years. You will receive a higher interest rate for the longer time commitment. You promise to leave all the money, plus the interest, with the bank for the entire term.

In effect, you are lending the bank your money in return for interest. The CD is a promissory note that the bank issues you. That's how banks acquire the cash they need to make loans. The interest you receive is less than the pay earns for lending it out. That's how banks earn a profit. But you earn a higher interest rate than you would for an interest-bearing checking account. That because you can't withdraw the funds for the agreed-upon time. 

Three Advantages

There are three advantages of CDs. First, your funds are safe. The Federal Deposit Insurance Corporation insures CDs up to $250,000. The federal government guarantees you will never lose your principal. For that reason, they have less risk than bonds, stocks, or other more volatile investments.

Second, they offer higher interest rates than interest-bearing checking and savings account. They also offer higher interest rates than other safe investments, such as money-market accounts or money market funds.

You can shop around for the best rate. Small banks will offer better rates because they need the funds. Online-only banks will offer higher rates than brick and mortar banks because their costs are lower. In addition, you would find higher-than-usual rates if you deposit sizable amount of cash in the form of Jumbo CDs.

Three Disadvantages

CDs have three disadvantages. The main disadvantage is that your money is tied up for the life of the certificate. You pay a penalty if you need to withdraw your money before the term is up. However, there are several types of CDs that provide a certain amount of flexibility, so don't forget to ask your bank about options.

The second disadvantage is that you could miss out on investment opportunities that occur while your money is tied up. For example, you run the risk that interest rates will go up on other products during your term. If it looks like interest rates are rising, you can get a no-penalty CD. It allows you to get your money back without charge any time after the first six days. They pay more than a money market, but less than a regular CD. (Source: "Certificates of Deposit," Ally Bank.)

The third problem is that CDs don't pay enough to keep up with the rate of inflation. If you only invest in CDs, you'll lose your standard of living over time. The best way to keep ahead of inflation is with stock investing, but that is risky. You could lose your total investment. You could get a slightly higher return without risk with Treasury Inflation Protected Securities or I-Bonds. Their disadvantage is that you'll lose money if there is deflation. 

CDs Versus Money Market Accounts Versus Money Market Funds

Certificates of deposit provide the funds for money market deposit accounts. As a result, their returns are slightly less than what you'd get on a CD. The benefit is you can take your money out at any time without a penalty. The other benefit is that if interest rates go up, you aren't locked into a fixed rate of return. Many people prefer this flexibility. Money market deposit accounts are also FDIC insured.

Money market mutual funds are select mutual funds that invest in CDs as well as other money market instruments. These are sold by a bank, your broker, or other financial institution. Like a CD, you can also withdraw funds at any time. The downside is the FDIC doesn't insure them. 

How CD Rates Are Set

Banks use the funds from issuing CDs to lend, hold in reserves, or spend for their operations. But they have many other choices. Those alternatives determine the interest rates banks pay on CDs.

The fed funds rate is the lowest-cost source of funds. The nation's central bank, the Federal Reserve, sets that rate. But banks can only use fed funds to meet the reserve requirement that night.

For other needs, banks borrow from each other at the Libor rate. That's the London Interbank Offer Rate. Banks pay that rate on one-month, three-month, one-year, and five-year loans. They pay more for Libor than they pay for CDs. But CDs costs them more because they have to administer them. They can just wire Libor loans to each other. They can also borrow much more than the typical CD deposit. 

CD rates will be lower than what they charge their best customers to lend money, known as the prime rate because banks must make a profit. Their revenue comes from interest paid by borrowers. Their costs are the interest paid to lenders, such as other banks, depositors in money market accounts, and deposits in CDs. Thus, rates paid on CDs will be higher than the fed funds rate, but lower than the prime rate.