Understanding the Downside of CDs for Young Investors

Certificates of deposit (CDs) are having a moment. Thanks to a higher-than-usual federal funds rate (intended to deal with inflation), rates on deposit bank accounts are up across the board. The average rate on CDs of all terms is under 2%, according to the FDIC -- but some individual banks and credit unions are paying upward of 5% on CDs, especially those with terms of less than two years.

Despite this good news, CDs might not be the best fit for you if you're a young investor. Let's take a closer look at how these accounts work, as well as their biggest downside: a lack of flexibility.

How do CDs work?

CDs are fairly straightforward bank accounts, assuming you can remember the rules. You open a CD account and lock your money up for the duration of the CD's term -- often three months to five years. The money accrues interest at the same rate for the entire time, and this can be paid out monthly in some cases (or you can leave it in the account).

Once the term is up, you'll usually get a grace period (often a week) to withdraw your funds. If you don't, they'll often roll into a new CD with the same term -- but often a different rate, depending on market conditions and the bank.

CDs come with FDIC insurance, meaning you won't be putting your money at risk by opening one. A variety of banks and other financial institutions offer them, sometimes without a minimum opening deposit, so you're not required to lock away a big chunk of money to benefit from CDs.

A lack of flexibility can be a problem

If you're just getting started with saving and investing, that lack of flexibility with a CD could work against you. When you open one, you start with a set amount of cash, and you generally won't be allowed to add more money during the CD's term. Let's say you open a 1-year CD with $1,000 that pays an APY of 5%. Over the year, you can expect to earn $50 -- not bad.

But if you find yourself with an unexpected windfall of $500 and you want to add that money to the CD, you won't be able to. You could of course open a new CD with your $500, but what if the Federal Reserve has lowered the federal funds rate by that point, and now CD rates have also fallen? That would be a bummer.

The fact that you're locking your money in for a set period can also pose a problem. If you're a new investor, the odds are good that you don't have a lot of cash at the ready that you can draw from in an emergency. I'd urge you to prioritize saving an emergency fund (honestly, even just having $1,000 in a savings account can help you sleep at night) before going too far down the investing road. That way, you don't find yourself cashing out investments when an unplanned bill arrives.

If you've got that same $1,000 1-year CD and no emergency savings, you'd have no choice but to cash it out if you have a surprise expense. And depending on how long your money has been in the account, you might find yourself losing some of your $1,000 to penalties if you haven't yet earned enough interest to cover them.

What should you do?

If you're just getting started with investing and harbor a curiosity about CDs, this lack of flexibility doesn't mean they have to be off the table entirely for you. In fact, if you already have a chunk of money saved up (after building an emergency fund) and want a guaranteed and predictable return on it, CDs are worth exploring.

That said, you can get a similar return on an account with more flexibility right now, like a savings or money market account. You won't be able to lock in a high rate on one of these, but at least you'll have access to your cash and can withdraw or deposit more.

Just take the time to evaluate all your options, as different financial institutions have different terms, minimum deposit requirements, and early withdrawal penalties. The Motley Fool Ascent's list of the best CD rates is a great place to start your search.