Certificate of Deposit (CD) | Definition

Although a Certificate of Deposit has a higher interest rate than other savings accounts, it typically does not keep up with inflation.

CDs vs. Money Market Accounts

Other than a traditional savings account, banks will often push customers to utilize CDs and Money Market Accounts (MMAs). To know which option is best for your situation, it is important to know the difference between these savings products.

Certificate of Deposit

Of the three types of savings accounts—traditional, MMA, and CD—a CD is the most illiquid, meaning you can’t just pull your money out at any time. Since CDs are locked in for a certain amount of time, banks can make conservative investments in stocks and bonds to offer you a guaranteed rate of return. This will not make a ton of money, but it will be a much higher interest rate than a liquid account like a traditional savings account since banks don’t know when you’ll remove that money.

Money Market Account

An MMA is a sort of middle ground between traditional savings and a CD. The MMA offers interest rates that are higher than traditional accounts but lower than CDs. The tradeoff here is that there are usually higher account minimum balances. Since the bank can at least guarantee a small amount in the account, they can make similar conservative investments as the CD.

Benefits of a Certificate of Deposit

There are several reasons that a CD is a good place to put your funds:

• The higher interest rate helps fight inflation while you are holding cash.
• Having funds behind a penalty wall makes it hard to spend them frivolously.
• Even though there are withdrawal penalties, that is only for the interest earned, which means your invested cash is usually safe.

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Drawbacks of a Certificate of Deposit

There are several reasons that a CD may not be the best place to put your funds:

• It is illiquid, so don’t put it there if you need the cash soon.
• The higher interest rates are usually below the inflation rate, so it is not an investment to beat inflation.
• Penalties can wipe out all of your interest, even late in your deposit’s maturity.

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The Money Wrap-Up: When to Consider Investing in a Certificate of Deposit

A CD is a medium-term conservative investment. Generally speaking, if you need cash in the next one or two months, you would not use a CD since the shortest is usually three months. On the other hand, a CD is not a long-term wealth-generating investment since it doesn’t keep up with inflation, so any funds held beyond a few years usually need to be invested elsewhere. 

There are other medium-term investments as well, such as short-term bonds, but even those can lose money. There are few investments as safe or non-volatile as a CD, so that makes CDs an important tool in your financial tool belt.