Explaining Certificates of Deposit (CDs)
If you've read anything about saving money on Finessin' Finances, you know we preach the importance of having emergency savings set aside for a rainy day or drought (if you know, you know). If you're single with no kids, you can get away with having three months' worth of living expenses saved up. If you're married or have kids—you know, responsible for someone other than yourself—your goal should be to have six months' worth.
If the higher-ups in corporate America decide to one day throw you out like Uncle Phil used to do Jazzy Jeff, you'll want to have a decent cushion until you can find employment.
Once you have this accomplished, however, any additional savings are better off elsewhere where you can receive higher interest rates than standard savings accounts. One such place is in certificates of deposit.
Explaining Certificates of Deposit (CDs)
Think of a CD as a loan to a bank or other financial institution. When you deposit money into a CD, you're loaning a bank money at a pre-determined interest rate for a specific period—usually between 1–10 years. The longer the term, the higher the interest rate.
During this time, the bank pays interest on the CD, but your principal (the original amount of the CD) is "locked away" until the end of the CD term. If you deposit $1,000 into a five-year CD, you might as well kiss that lil' stack goodbye for five years.
If there's a good chance that you're going to need the money deposited into a CD before its maturity date (the end of its term), you may want to consider another option.
Withdrawing Your Money
Liquidity generally refers to the ability of an asset to be converted into cash. The easier it is to sell, the more liquid it's considered. If you own stocks, they can quickly be sold on the market for cash; if you own large machinery, it will likely be harder to sell. While a CD isn't quite the poster child for illiquid assets, it's definitely leaning on that side of the aisle.
If life happens—as it tends to do—and you need the money from your CD, you can expect to get hit an early-withdrawal penalty. The amount of this penalty varies by bank, but it's usually a set amount of interest based on the length of the CD. For example, if you withdraw early from a 2-year CD, Wells Fargo will penalize you six months' worth of interest payments (with a $25 minimum); Ally Bank will penalize you two months' worth.
If you deposited $1,000 into the above CDs at a 2.25% APY rate, your Wells Fargo penalty would be $25 ($11.25 without the minimum requirement), and your Ally penalty would be $3.75.
The Main Advantages
Risk-Free
The main advantage of CDs is they're 100% risk-free up to $250,000. Like your regular checking or savings account, the Federal Deposit Insurance Corporation (FDIC) insures the money you deposit into a CD. No matter what happens, Uncle Sam 'nem guarantee you'll never lose a penny of your principal.
If you deposit $249,999.99 into a CD with WeFinnaGoBankrupt Bank and they... well... go bankrupt, you can count on getting all of your money back.
Better Rates
Unless you're banking online or with a credit union, chances are that the interest rates you're receiving on your checking and savings accounts are lower than the Black population in Maine. CDs allow you to earn extra money on your savings that you [hopefully] won't need anytime soon.
If you have an emergency savings, there's no need to leave extra money in an account that's offering less than 1% interest when you can double that elsewhere with no additional risk. That's like two gas stations being side-by-side and you purposely choosing the one with higher gas prices.
Predictability
Unlike the stock market, there's no guessing when it comes to your returns on CDs; it's as straightforward as African parents. You know how much you're getting and how often you're getting it. If your APY is 2%, you know you're getting 2% back each year. It doesn't matter if the economy is doing worse than the Detroit Lions or flourishing like the weed business in California—you're getting your 2%.
Lots of Options
Luckily, there are more CDs available than Old Town Road remixes. Want one for three months? No problem. Want one for five years? It's right there for you. Saving for your child's college fund and want one that matures in 10 years? It's all yours, big dawg. The huge variety of CDs helps people save for specific life events and stagger maturity dates to receive consistent passive income.
The Main Disadvantages
Money Is Not Very Accessible
The main downside with CDs is that you can't easily access your money once you've deposited it. The fee you pay for an early withdrawal may wipe out any money you've earned, and in some cases, it could cost you some of your principal.
For example, if you haven't earned $25 in interest with your Wells Fargo CD and have to make a withdrawal, you'll end up losing money. You basically paid them to hold your money when you could've just kept it in a savings account for $Free.99.
Low-ish Returns
Although CDs offer better rates than most traditional checking and savings accounts, their rates are still low compared to other investments like stocks and bonds. Of course, there's more risk involved with stocks and bonds, but there are still plenty of safe-enough options that make investing your money there worth it.
For perspective, the annual stock market return has been around 10%. If you invested $1,000 one year in the stock market and didn't add another penny, that investment would be worth over $2,500 in 10 years. If you put that same $1,000 into a 10-year CD, it would be worth around $1,300.
Inflation Risk
Simply put, inflation is the steady increase in prices of seemingly every damn thing. If you put your money into a long-term CD—say, 5–10 years—there's a slight chance that the interest rate you earn will lag behind the rate of inflation. If your CD offers 1.5% in interest and inflation increases by 2% during that time, you essentially hustled backward. You might have not technically lost money, but the purchasing power is less than when you first deposited it—which defeats the purpose.
The Purpose of Certificates of Deposit
While CDs give people a chance to earn a little extra money on their savings, banks may be the real beneficiaries. When you deposit money into a CD, this becomes a loan to the bank. The bank then turns around and uses that money to lend out at higher rates to people looking for personal and business loans.
You may be earning 2% from a CD, but the bank is using that same money to lend to somebody at a 7% interest rate, pocketing the 5% difference. The game is the game.
Instead of putting a lot of money into a long-term CD, choose multiple shorter-term CDs with varying maturity dates. This will give you a consistent flow of income that you can count on, and it occasionally frees up your money to use it for more lucrative opportunities.