10 Pros and Cons of Investing in CDs

Consumer interest rates are at their highest level in years, and several top-notch financial institutions are offering yields of 5% or higher on certain types of CDs. Certificates of deposit, or CDs, are far more appealing places to keep cash than they were just a few years ago. But like any other account, they have pros and cons to consider.

For example, while CDs allow you to lock in a certain interest rate for a certain amount of time, they also come with penalties if you withdraw your money early.

With that in mind, here's a list of 10 benefits and potential drawbacks of putting your cash in a CD, so you can make the best decision for your own financial situation.

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You may have noticed that savings accounts are also paying higher interest rates than they have in years, and in some cases, they rival the rates paid by CDs. However, unlike savings accounts, CD interest rates are set for the entire length of the term. If you get a 5-year CD with a 4.00% APY, that's the rate you'll get for the entire five years. On the other hand, savings account interest rates can (and do) fluctuate over time.

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As long as you put your money in a CD offered by a reputable FDIC-insured bank, your CD funds are safe. CDs are FDIC insured up to a maximum of $250,000 per person, per bank, and some banks have even taken steps to increase the limits beyond these amounts. Unlike putting your money in the stock market, there is no reason to worry about your money in a CD.

Savings accounts may offer interest rates that are comparable to those offered by CDs, but you'll find a better yield on your money with a CD. This isn't always the case, but if you compare a 1-year or 18-month CD with a savings account offered by the same financial institution, you're likely to find a significantly higher yield from the CDs. So, not only can you lock in an interest rate for the entire term, but you can get a higher rate of return as well.

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It's a common misconception that all the money in your CD must be left alone for the duration of the term. That's true when it comes to the principal (the money you deposited), but in many cases, banks will allow you to withdraw the interest you get paid, as it comes in. In other words, if you deposit $10,000 into a 5-year CD at a 4.00% APY, you'll receive $400 in interest during the first year. Assuming your bank allows it, you can withdraw the $400 (or part of it), or you can choose to leave it in the account to compound.

You can buy CDs through individual retirement accounts, or IRAs. This can help you diversify your portfolio away from the stock market or supplement fixed-income investments.

By putting your money into CDs within an IRA, you won't have to pay income tax on the interest your account generates each year. Most major brokerage firms offer CDs to their clients, and some banks allow you to open an IRA directly with them to hold your CDs.

CDs are available in a variety of term lengths. Most banks offer CDs ranging from six months to five years, although some offer non-standard maturity terms. There are some that offer 7-year or 10-year CDs for those who want long-term income streams, and some offer short-term CDs (say, three months) for people who simply want to park their cash for a little while. Savers can also use the variety in term lengths to create a CD ladder -- which is a series of CDs with staggered maturity dates to combine financial flexibility and long-term yield visibility.

Unless you hold your CDs in retirement accounts, as mentioned earlier, interest paid on a CD is generally considered to be taxable income. It's well known that interest income is taxable, but many people don't realize that CD interest income is taxable even if you don't withdraw it. For example, if you have a 5-year CD and don't touch the account for the entire five years, you'll have to report all of the interest you were paid each year on your tax return.

If you take money out of your CD before it reaches maturity, you will likely have to pay an early-withdrawal penalty. In most cases, an early-withdrawal penalty is equal to a few months' worth of interest -- it depends on the financial institution's policies and the maturity term of the CD. Some banks offer no-penalty CDs that have a steady interest rate but that allow you to withdraw your money at any time, but these typically offer relatively low interest rates compared to standard CDs.

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While having a consistent interest rate for the entire term is a positive factor of CDs, it can also be a potential drawback in a rising rate environment.

Think of it this way. Let's say that you open a 5-year CD with a 4.00% APY, and over the next year, the bank's 5-year CD yield rises to 6.00%. Now you're stuck earning 4.00% on your money (or paying a penalty for early withdrawal) for another four years. While most experts aren't expecting rates to rise much further (if at all) from current levels, if they do, CD owners could regret locking in today's rates.

Depending on how you look at it, this can be a pro or a con of CDs. But in most cases, CDs will renew automatically upon maturity, unless you take action to withdraw the money during a time window specified by your bank (usually starting a week or two prior to maturity). In other words, if you have a 1-year CD and don't do anything, it will renew for another year at whatever the bank's current 1-year CD rate is at the time.

CDs can be an excellent way to get a stable yield from money you aren't going to need anytime soon. But keep the drawbacks and risks in mind if you're deciding whether to open one.

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Matt Frankel has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.