For many years, certificates of deposit were sold to people as a financial product that would make a profit and never lose value. In fact, CDs posted interest rates around 5% or more for a number of years, providing a good return on investment.
Because of this, many people used CDs to save for major life events, such as retirement and college. Today, however, certificates of deposit have severely dropped in popularity.
How It Works
In order to answer this question, it's first necessary to understand what a CD is and how it works. CDs are savings certificates sold by banks. An investor purchases a CD for a set period of time at an interest rate determined by the bank. At the end of the time period, it is possible to redeem the savings certificate for the amount of the original deposit, plus interest earned.
How It Was Used
When interest rates, as set by the Federal Reserve, were high, many people used CDs for their long-term savings. They bought a series of these certificates so they could take advantage of the highest interest rates while still having regular access to their money. This arrangement was ideal for parents who wanted to pay for college tuition for several consecutive years or retirees who needed a stream of steady and reliable income.
Certificates of Deposit Today
For many years, now, interest rates have been historically low. While this is great news for those needing a loan, it's terrible for investors looking for a way to safely grow their savings. Today, most CDs offer rates that are so low, a person's savings have no way of beating inflation. While a year or two of low returns typically isn't a problem for a long-term investor, it can be an issue if the low interest rates persist for nearly a decade.
By not having your money earn enough to keep up with inflation, you're essentially losing purchasing power each year. This means that these investments aren't really as secure as believed. You might not lose your principal, but you won't be able to buy as much with the money when you take it out as you were when you put it in.For this reason, it's generally recommended that people look somewhere else for a long-term investment. While riskier, investments such as corporate bonds can offer a better rate of return.
Instead of relying solely on CDs, investors should also consider developing a well-balanced portfolio that includes a variety of securities including stocks, bonds, and perhaps even some exposure to commodities or real estate. The truth is that everyone needs to create a tailored investment plan; not simply rely on what the local bank is offering. Take the time to really set your investment goals, develop an investment plan, and review your portfolio.
In the short term, however, CDs might still make sense as an investment. People looking for a place to store their money for less than a year while they wait to make a large purchase, such as a home, or decide on an investment strategy can see several advantages to using certificates of deposit.