When planning your financial future, it’s tricky to strike a balance between earning meaningful interest and keeping your money safe. But many individuals find that certificates of deposit (CDs) offer this exact balance.

Read on to explore the pros and cons of CDs and better understand whether this is the right saving strategy for you.

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What’s a certificate of deposit, and how do they work?

With a CD account, you deposit your money with a bank for a predetermined time period. In return, the bank pays you a fixed interest rate. When your CD matures, the bank returns your principal to you, plus any interest earned over the CD’s term. You can take the money (and run) or roll part or all of your proceeds over into a new CD.

CDs are quite flexible — you can choose from a wide range of terms regarding length and interest rate. And as you accrue interest, the bank adds those earnings to your principal, then calculates subsequent interest payments based on that new, larger principal (a process that’s known as compounding interest).

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Pros of having a CD

On the upside, CDs offer a straightforward structure and competitive savings rates, particularly when compared to standard savings accounts. Here are the main benefits of having a CD.

Easy-to-understand investment

The only major difference between a CD and basic savings account (besides interest rates) is that you agree to keep your money tied up for a fixed period of time. So they’re pretty simple to understand, open, and manage.

Guaranteed returns

With a CD, using the term and stated APY, you can calculate how much interest you’ll earn. Unlike a traditional savings account, where the interest can fluctuate, these returns are exact and guaranteed.

Low risk

The Federal Deposit Insurance Corporation (FDIC) insures money in a CD account the same way it does checking and savings accounts — up to $250,000 per depositor, per insured bank. This guarantee makes CDs one of the lowest-risk investments you can make.

Plus, a CD isn’t tied to the stock market or even general economic conditions. Once you’re in a CD, your interest rate is set — there’s no volatility, and your rate won’t change during the term, no matter what happens in the market or with Federal Reserve decisions on interest rates.

Higher interest rates than savings accounts

The average interest rate on a high-yield savings account is 0.61%. On average, CDs are higher, at 1.86%.

Variety of term lengths

CD terms run the gamut, from one month to several years. This means you can choose something that perfectly suits your current financial situation and long-term goals.

This also makes CDs great for short-term financial goals. If you know when you’ll need your money, you can select a CD term that corresponds with that timeframe. When the time comes to use that cash, you’ll have your principal, plus a little bit of interest, available to spend.

Can be laddered for better liquidity management

You can spread your savings across multiple CDs with different terms using a strategy called CD laddering. This ensures that you have some portion of your cash accessible at regular intervals and gives you a better chance of securing higher interest rates over time.

No-penalty withdrawals on some accounts

Some CDs are no-penalty, meaning you can withdraw anytime without restrictions, but these accounts also typically offer lower interest rates.

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Cons of having a CD

While CDs are an easy-to-understand, low-risk way to grow your savings, here are some of the disadvantages of CDs so you can decide whether the pros outweigh the cons.

Limited liquidity

Unless you’re okay paying an early withdrawal penalty — usually equal to a certain number of months of interest — or getting a lower interest rate overall, you have to wait until your CD matures to withdraw money.

Inflation risk

The longer you keep your money locked up in a CD, the more you risk its growth not keeping up with the pace of inflation. As the cost of consumer goods increases in price, the purchasing power of your money decreases.

Lower returns compared to stocks

In this same vein, stocks — and other more aggressive investments — offer a better chance of generating returns that are higher than the current and future inflation rate. Generally, you can make (or lose) more money off of higher-risk investment products.

Interest rates are locked in, even if rates rise

The interest rate you secure on a CD might look great today, but if interest rates rise, it might not feel like such a great deal tomorrow. Once you’re locked into a CD, you have to wait for its term to expire to get into an account with a better rate (unless you choose to open another CD).

Minimum deposit requirements can be high

While they vary considerably across banks and CD products, common certificate of deposit minimum balance requirements can be prohibitive. To earn a higher rate, some banks require a heftier minimum deposit.

No additional contributions allowed after opening

Once you open a CD account, you can’t add to your principal. Only interest gets tacked on, not additional contributions, meaning you can’t do the work to help your money grow the way you can with other more flexible investments, like annuities.

Some banks charge fees for early withdrawals

No-penalty CDs exist, but they’re relatively rare. Expect to pay a fee for early withdrawals from a CD. These fees differ between banks but generally look like this:

• CDs under 12 months, you pay three months of interest
• CDs from one to five years, you pay six months of interest
• CDs over five years, you pay 12 months or more of interest

Taxable interest earnings

Unlike many annuities and other investment types, CDs don’t grow tax-deferred — you’re responsible for taxes on interest earned in a CD account now, not come retirement.

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An overview of the pros and cons of CD accounts

Here’s an outline of the pros and cons to give you a bird’s-eye view and help you compare the two.

Pros

• Guaranteed returns and no market-related risk

• Higher interest rate than savings accounts

• Good for short-term financial goals

• Some CDs offer no penalty for early withdrawals

• You can ladder CDs to better manage liquidity and interest rates

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Cons

• Lower returns compared to stocks, other investments

• Not immune to inflation risk

• Interest rate is locked in for the life of the CD

• Not ideal for long-term investing

• Most CDs charge a penalty for early withdrawals

• Limited liquidity relative to savings accounts and some other investments

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Are CDs a good investment?

The best way to determine whether a CD is worth it is to consider your risk profile and savings goals. If you just want to earn a few dollars on your savings, CDs make it easy to sleep at night — they’re low risk, plus you know exactly what you’re getting and for how long.

Conversely, locking in an interest rate means you could be leaving money on the table, compared to other more lucrative opportunities.

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Tax implications of CDs

As with any investment strategy, it’s crucial to understand how taxes will impact your earnings. Here’s an overview of the relationship between CDs and the IRS:

• Are CDs taxed? Unless you own a CD inside a tax-advantageous account like an IRA or 401(k), you must pay taxes on your CD earnings.
• When do you pay taxes on CDs? You’ll pay taxes during the normal yearly tax season — before then, your CD provider will send you the form needed to fill out your taxes.
• When are taxes due on CD interest? Because you pay taxes on CD interest as part of your overall tax due, the deadline is typically the one set by the IRS for you to file your return and satisfy your obligation. Miss this deadline and you could face penalties.

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How to choose the right CD: Three considerations

Decided this investment strategy is worthwhile? Here are a few things to consider when choosing a CD provider and contract.

1. Be strategic about the contract’s term length

Determine whether your CD savings strategy is short, medium, or long-term, and choose a contract length that aligns with this goal. If you plan to use a laddering strategy, decide on staggered term lengths for each CD to ensure you have regular access to funds while maximizing interest earnings.

2. Do your research to find the best percentage yield

If you think interest rates will drop in the near future, locking in a high rate on a CD now could be a smart move. For example, if you secure a 4% rate on a multi-year CD while rates are falling, your savings will continue to grow at that higher rate, even as new CDs start offering lower yields. So compare provider rates, check rate trends online, and lock in a fixed rate to make sure you’re earning more interest compared to what might be available in the future.

3. Choose the CD with the least minimum deposit required

For greater flexibility — especially if you’re using a CD laddering strategy — consider CDs with low minimum deposit requirements. This allows you to distribute your cash across multiple CDs (taking advantage of different maturity dates) and still keep funds available for other potentially higher-yield investments.

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Annuities vs. CDs

While annuities often come with more risk and increased fees compared to CDs, that’s not always the case. Some insurers remove the middleman to eliminate hidden administrative, maintenance, and commission costs — something you won’t avoid when buying a CD. Plus, you’ll typically get a higher rate of return with an annuity, so more money stays in your pocket. There’s an annuity for almost every goal, usually offering increased flexibility compared to CDs.

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This communication is for informational purposes only. It is not intended to provide, and should not be interpreted as, individualized investment, legal, or tax advice.