Certificates of Deposits and Bonds: How They Work

Many of us are working to achieve our financial resolutions now that we are a few months into the new year. With tax season approaching, you may be thinking about how you can make your tax return work for you. How can you make your money grow? This is where a Certificate of Deposit or bond may be able to help.

Certificates of deposit and bonds are two types of investments that may be able to provide higher interest rates than a traditional savings account. But each type of investment has its own differences, pros, and cons. CDs, for example, are often thought of as a type of savings account. And bonds, on the other hand, are usually associated with investment vehicles such as stocks and mutual funds.

Keep reading to learn more about CDs and bonds, including how they work and whether they might be a good investment for you, especially in an inflationary environment.

How a Certificate of Deposit Works

A Certificate of Deposit, or CD, is a type of savings account that holds a set amount of money for a set length of time. When you open a CD, you are essentially putting money away for a future date in exchange for the guarantee of a certain interest rate.

That later date is referred to as the "maturity date.”. That means you have to leave your money in the account until the CD matures. You will be charged an early withdrawal penalty if you need to remove it early. The maturity dates of CDs usually range between three months and five years. Typically, the longer you keep money in an account, the more interest it earns.

One significant advantage of CDs is that they typically yield a higher interest rate on your money than other kinds of accounts can. While you’ll have limited access to your funds, you’ll also be rewarded with that higher interest rate.

A CD may be the best option for you if you want to earn a potentially higher rate on your savings in a low-risk environment. But remember: They are best when you do not require immediate access to the money.

Keep in mind that most CDs have a minimum deposit, such as $500. They may not be right for you if you’re looking to set aside an amount lower than that.

The Pros and Cons of CDs

Pros

Interest rate: CDs typically offer higher interest rates than other types of savings accounts.

Low risk: CDs are FDIC-insured, and you also don’t have to worry about the volatility that comes with other investment options.

Guaranteed return: As long as you leave the money in the CD until the maturity date, you don’t have to worry about losing money.

Cons

Penalties: If you withdraw your money from the CD before the maturity date, you’ll be subject to financial penalties.

Lack of flexibility: If you do need to withdraw your funds early, the money isn’t as accessible as it would be in a traditional savings account.

Interest rate: While the interest rate for a CD is generally higher than with other types of savings accounts, it still may be low compared to other investment options, though those other options come with more risk.

How Bonds Work

Understanding how CDs work may make understanding bonds simpler, as they share some similarities. For example, both are lower-risk investments with modest yields and maturity dates.

However, bonds are unique in that they are typically issued by a government or corporation as a means of raising funds. As the buyer of the bond, you’re acting as the lender. When you buy a bond, you’re basically allowing the government or corporation to borrow your money in exchange for a predetermined rate for a set amount of time.

After that set period passes, the entity from which you bought a bond is obligated to pay your money back. Typically, you’ll receive your interest in periodic payments throughout the length of time you’re holding your bond, such as twice per year.

One common type of bond is the I Bond from the U.S. government. I Bonds are designed to help bond purchasers protect themselves from inflation, because as the inflation rate increases, so does the interest rate paid by the bond.

Those who choose to invest in I Bonds must hold them for a minimum of 12 months, with a three-month interest penalty if they cash out before five years. However, the minimum investment in an I Bond is only $25.

The Pros and Cons of Bonds

Pros

Interest rate: Some bonds, such as the I Bond from the U.S. government, are able to help protect consumers from inflation by periodically raising interest rates to keep pace with inflation.

Low risk: While bonds aren’t FDIC-insured like CDs, government-issued bonds and highly rated bonds from corporations are typically safe. The only chance of losing your principal would be if the organization goes bankrupt, and even in that case, bondholders are repaid before stockholders.

Low minimum investment: Unlike other types of low-risk investments, you only need $25 to get started investing in bonds such as the I Bond.

Cons

Inflation risk: Not all bonds are like I Bonds, which are meant to counter inflation. If you buy bonds that offer set interest rates and don’t keep pace with inflation, you could “lose” money -- or at least purchasing power.

Low returns: Compared to the potential return on other types of investment vehicles, such as stocks or mutual funds, the return on bonds is typically lower than that of stocks.

Lack of FDIC insurance: While the chances of a highly rated bond-issuing entity defaulting on its repayment of the bond and going bankrupt is low, there’s still a small risk. Bonds are not FDIC-insured.

Investing in CDs or Bonds During an Inflationary Environment

Inflation is a topic that is on many people’s minds right now -- in the U.S. and around the world. Which leads you to the question: Is it worthwhile to invest in CDs and/or bonds?

With inflation rates higher than the interest rates on CDs, they may not appear to be a good investment. However, when you consider what they're meant to do -- help you preserve your existing funds while earning a little extra money -- they may be a better choice than a traditional savings account.

With bonds, it’s typically the same story, unless you’re considering an I Bond. That’s because I Bonds are designed to keep pace with inflation, meaning you don’t have to worry about losing purchasing power.

Ultimately, CDs and bonds can help add that little bit extra on money that might otherwise be collecting dust in a traditional Savings Account. But they aren’t designed to help you gain large amounts of wealth.

Academy Bank Is Your Financial Partner

No matter your financial goals, Academy Bank is by your side. And we are proud to offer CD accounts with competitive interest rates.

Learn more about all the types of savings options we offer. If you're thinking about or nearing retirement, you can also talk to your advisor* about turning your Certificate of Deposit into a Traditional IRA, Roth IRA, or SEP IRA plan.

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*Consult with a tax advisor regarding the deductibility of interest.