Now that we are a few months into the new year, many people are working toward meeting their financial goals. And with tax season on the horizon, you may be wondering how you can put your tax return to work for you. How can you make your money grow? That’s where a certificate of deposit (CD) or bond may come in.
Certificates of deposit and bonds are two types of investments that may offer higher interest rates than a traditional savings account. However, CDs can be seen as a type of savings account, while bonds are typically grouped with investment vehicles such as stocks and mutual funds.
Keep reading to learn about CDs and bonds to find out how they work and whether a CD or bond could be a good investment for you.
How Do Certificates of Deposit Work?
Acertificate of deposit, also known as a CD, is a type of savings account that holds a set amount of money for a set period of time. When you open a CD, you're basically putting money aside for a later date -- in exchange for the promise of a certain interest rate.
With a CD, that later date is referred to as the "maturity date." That means you must keep your money in the account until the CD reaches that maturity date. If you need to withdraw it early, you will be subject to an early withdrawal penalty. The length of time for CD maturities typically ranges between three months and five years. The longer you leave the money in an account, the more interest it can make.
One major benefit of CDs is that they can typically earn you a higher interest rate on your money than with other types of accounts. That’s because, while your money is sitting in the account until its maturity date, the bank essentially has the option to borrow your money during that time. The reward is that higher interest rate. But at the same time, you have restricted access to your money.
A CD might be the right choice for you if you want to earn some interest on your savings in a low-risk way. But they’re best when you don’t need immediate access to those funds.
Remember: CDs typically have a minimum deposit or balance requirement, such as $500. They may not be right for you if you’re looking to set aside an amount lower than that.
What Are the Pros and Cons of CDs?
Pros
Interest rate: CDs typically offer higher interest rates than other types of savings accounts.
Low risk: You don’t have to worry about the volatility that comes with other investment options, such as the stock market. And CDs are FDIC-insured.
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, as the return is guaranteed -- along with any interest.
Cons
Penalties: If you withdraw your money from the CD before the maturity date, you’ll be subject to financial penalties.
Lack of flexibility: In the case that you do need to withdraw your funds from a CD early, the money isn’t as readily available and accessible as it would be in a savings account, for example.
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 types of investments (though these usually come with more risk).
How Do Bonds Work?
After understanding how CDs work, it may be easier to understand bonds, as they share some similarities. For example, both are low-risk investments that offer modest returns and operate with a maturity date.
But bonds are unique in that they are generally offered by a government or corporation as a way for that organization to raise money. The investor, or the person buying the bond, acts as the lender. Again, you’re essentially allowing the government or corporation to borrow your money for a set period of time in exchange for interest.
After that set period of time passes, the organization 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 theI 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, though cashing out before 5 years means a loss of three months’ interest. However, the minimum investment in an I Bond is only $25.
What Are 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 low.
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
Inflationis a topic that is on many people’s minds right now -- in the U.S. and around the world. Which may cause you to wonder: Is it worth it to invest in CDs and/or bonds?
For CDs, interest rates that are lower than the inflation rate may not seem to be a good investment. But if you look at them in terms of what they’re meant to do -- help you preserve the funds you already have, while making a little bit on top -- they may be a better choice than a traditional savings account.
With bonds, it’s typically the same, 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.
Armed Forces Bank Is Your Financial Partner
No matter your financial goals, and no matter where you’re stationed in the world, Armed Forces Bank is by your side. And we are proud to offerCD accountswith competitive interest rates.
Learn more about all the types ofsavings 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 aTraditional IRA or Roth IRA.
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*Consult with a tax advisor regarding the deductibility of interest.
