What Is a CD or Certificate of Deposit?

When building a diverse investment portfolio, many investors look for ways to balance higher-risk options like stocks with more conservative choices. One low-risk savings tool to consider is a bank CD (certificate of deposit). CDs can offer predictable returns and help protect your savings from market fluctuations, which can be especially appealing if you're looking for more stability in your financial plan.

Before deciding if a CD fits your goals, it's helpful to understand how they work and how they may fit into your overall investment plans. Here's what you need to know about a bank CD's potential benefits and limitations.

How does a bank CD work?

Certificates of deposit are relatively straightforward. You deposit a sum of money for a set period—anywhere from a few months to several years. In return, the bank offers a fixed interest rate for the term. Generally, the longer the term, the better the interest rate. At the end of the term, known as the maturity date, you can withdraw your initial deposit plus the interest earned.

Suppose you have $10,000 to invest. You can open a CD with that $10,000 for a two-year term at a 5% interest rate, and your money earns interest over those two years. By the time the CD matures, you'll have your original $10,000, plus $1,025 in interest. With a CD, you get a predictable return with no surprises from market swings.

However, CDs aren't always the most flexible option. Your money is locked in until the CD matures; withdrawing early usually means paying a penalty. For this reason, CDs are often best for funds you don't plan on needing for the duration of the term.
 

The pros and cons of a bank CD

As with any financial tool, CDs have advantages and limitations for investors. Understanding these can help you decide whether a CD aligns with your risk levels and financial goals, especially if you're exploring how to diversify a portfolio.

Pros:

• Safety: CDs are FDIC-insured, so your money is protected up to $250,000 per depositor, per bank. This guarantee makes them a very low-risk savings option.
• Predictable returns: Since CDs have fixed interest rates, you'll know exactly how much you'll earn when the CD matures. CDs can appeal to many investors who like the idea of low-risk, predictable growth.
• No market risk: CDs aren't tied to the stock market, so they don't fluctuate with ups and downs. If you want to avoid market volatility, a CD can be an option to explore adding to your portfolio.

Cons:

• Locked-in funds: Your money is locked in for the length of the CD term. If you need it before then, you'll likely face an early withdrawal penalty, which can eat into earnings.
• Lower returns: CDs tend to offer lower returns compared to stocks or other higher-risk investments. They may not be the right fit if you want significant long-term growth.
• Inflation risk: CDs may not keep pace with inflation, meaning your money could lose purchase power over time.

How a CD can help you build a diverse investment portfolio

A certificate of deposit can be one approach for adding some stability to your investment portfolio. While the returns often aren't as high as other investments like stocks or mutual funds, CDs are predictable and secure, which can be appealing if you're looking to balance out your higher-risk assets.

For example, during times of market volatility, having a portion of your money in a CD can provide stability. You know this investment won't be affected by market swings, so it's a way to protect part of your portfolio while still saving money and earning interest.

Some investors use CD laddering—opening several CDs with different maturity dates. That way, you can get the benefit of higher, longer-term interest rates while having regular access to part of your funds as each CD matures. It's a flexible strategy that can help you keep some liquidity in your portfolio while still earning predictable growth on the funds waiting for maturity.
 

Is a CD a good investment?

Whether a bank CD is a good investment depends on your financial goals and time horizon. Speaking with a certified financial planner may help you decide.

For those seeking a low-risk way to earn predictable returns, a CD can offer security against market uncertainty. It's FDIC-insured, so your principal is protected, and the fixed interest rate guarantees a return. So, if you're looking to park money safely without needing access to it, a CD may be a useful option.

On the other hand, if you're focused on long-term growth or need more flexibility to access your funds, the lower returns and early withdrawal penalties may make CDs less appealing than other investments.

CDs may appeal to more conservative savers or those who want to diversify their portfolios with a stable, low-risk asset. However, consider how much risk you're comfortable with and your financial needs over the next few years. CDs can help balance a diverse investment portfolio, but they work best when aligned with your specific goals.

Finding balance in your investment strategy

Whether you're aiming for predictable returns or balancing higher-risk investments, a bank CD can offer a low-risk option that fits into your broader financial plan. While it may not generate the high growth of assets like mutual funds, stocks or real estate, CDs can provide stability and safety, making it an option to explore.

Before deciding if a certificate of deposit is right for you, consider speaking with a financial advisor. They can help review your current situation and future goals and make a plan to help you find the investments that align with your long- and short-term financial goals.