Certificates of Deposit: Pros and Cons

Should You Buy Certificates of Deposit or Money Markets?

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Should you put your savings in CDs, money markets, or money market funds?. Photo: Blend Images - Jose Luis Pelaez Inc/Getty Images

Definition: A certificate of deposit (CDs) is an agreement to deposit money for a fixed period with a bank that will pay you interest. It's usually for three months, six months, one year or five years.  The bank pays a slightly higher interest rate the longer the term. You promise to leave all the money, including the interest, with the bank until the period is up. In reality, you are lending the bank your money in return for interest.That's how banks acquire the cash they need to make loans.

Advantages

The FDIC insures CDs up to $250,000. That means you will never lose your principal. For that reason, they have less risk than bonds, stocks or other more volatile investments.

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 also shop around for the best rate. Small banks will offer greater rates because they need the funds. Online-only banks will offer higher rates than brick and mortar banks because their costs are lower.

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 take back your money before the period is up. That means you run the risk that interest rates will go up on other products while your money is tied up in the bank. 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.)

CDs usually don't pay enough to keep up with the rate of inflation. The best way to do that without risk is with Treasury Inflation Protected Securities (TIPS) or I-Bonds.

CDs vs. Money Market Accounts vs. 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. The FDIC doesn't insure them. Make sure you ask before investing.

How Are CD Rates Set?

Banks that issue CDs use them to borrow funds, which they either lend, hold in reserves, or spend for their operations. When they look to borrow funds, they have many choices.

The cheapest is to pay the Fed funds rate, which is set by the nation's central bank, the Federal Reserve. However, they can only borrow Fed funds to use 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, and its charged for one-month, three-month, one-year, and five-year loans.

The interest rate they pay each other is slightly higher than what they pay you for CDs. That's because administering CDs costs them more than just wiring funds 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, know as the prime rate. That's 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. That's why the rates paid on CDs will be higher than the Fed funds rate, but lower than the prime rate.