Certificates of deposit, or CDs, and bonds are relatively safe vehicles to grow your money over time. But the two function very differently, and understanding these differences can help you determine which one is the better option for you.
If you have some cash and want to know whether to put it in bonds or CDs, here's what you need to know.
A CD is a type of bank account that offers a fixed interest rate on your balance in exchange for leaving your money in the account for a specified period of time. Depending on the financial institution, CD terms can range from one month to 10 years.
In most cases, you can't add money to your account after your initial deposit, and you can't withdraw any funds from the account until after it matures. If you do, you'll be charged an early withdrawal penalty.
After a CD matures, it'll typically renew automatically for the same period. However, you'll usually get a window of seven to 14 days to withdraw your funds or add more money to your balance.
Go deeper: What is a CD?
A bond is a type of investment in which you, as the investor, loan money to the bond's issuer, which may be a company or a government agency. In exchange, you'll receive a fixed interest rate and recurring payments of that earned interest — typically semi-annually — until the bond matures.
For example, if a bond has a $1,000 face value and a 6% interest rate, you'll receive $30 in interest payments every six months.
Depending on the type of bond, the maturity date can be anywhere from a few weeks to 30 years in the future. Throughout the bond's term, its value may fluctuate according to market interest rates — as interest rates go up, for instance, bond values go down. Once the bond matures, however, you'll receive the face value.
Although it's possible for investors to buy individual bonds, usually in $1,000 increments, it's more common to buy them through mutual funds and exchange-traded funds, or ETFs.
As you think about where to put your money, you may be wondering, is a CD a good investment? What are the risks associated with bonds? Here's what you should keep in mind.
CD terms can range anywhere from one month to 10 years, and in most cases, you can't access your money without paying a penalty until your CD matures. Some financial institutions offer penalty-free CDs, but they typically offer lower interest rates than standard CDs.
Depending on the type of bond you buy, terms can range from a few weeks to 30 years. However, you're not stuck with the investment for the full term; you can sell your bond at its current value at any point.
Also, if you're buying bonds through mutual funds or ETFs, you can sell your shares at any time.
CDs are offered by banks and credit unions, which means that your funds are typically insured for up to $250,000 per person, either through the Federal Deposit Insurance Corp., known as the FDIC, or the National Credit Union Administration, or NCUA, in the event that your bank or credit union fails.
Bonds, on the other hand, are issued by corporations and government agencies. Bonds purchased from government agencies tend to be safe, and bonds purchased through a brokerage firm may be insured for up to $500,000 by the Securities Investor Protection Corp. if the broker fails.
However, if you purchase a bond from a corporation and the company goes bankrupt, you risk losing your investment.
Returns for CDs and bonds can vary significantly, and in most cases, bonds offer higher returns, albeit with more risk involved.
CD rates will vary based on a number of factors, including the term length, the financial institution, and the overall interest rate environment. Many traditional bank or credit union CDs offer very low interest rates — typically expressed as an annual percentage yield, or APY. However, you may find online banks and financial institutions offering high-yield CD rates to compete for deposits. The difference may be huge: The corner bank might offer 1% even as an online competitor pays 4% or better.
Bond returns also can vary significantly depending on the type of bond and the risks associated with it. For example, bonds issued by the US Treasury tend to be the safest, but they also offer the lowest returns.
In contrast, corporate bonds can offer higher returns — particularly if the company has a less-than-stellar credit rating — but they also carry the highest risk of default.
Unless you opt for a penalty-free CD, you'll be assessed a fee for accessing your funds before your account matures. A common penalty may be 90, 180, or 270 days' worth of simple interest.
If you sell a bond before it matures, you'll miss out on future interest payments and the final par-value payment, but there are no penalties.
CDs are considered a risk-free place to put your money because, barring an early withdrawal penalty, your principal balance won't go down. And as long as you don't have more than the maximum insurance amount set by the FDIC or NCUSIF, your funds are safe even if your financial institution fails.
That said, CD rates are typically lower than the prevailing inflation rate, so your money can lose spending power over time.
While bonds tend to be less risky than stocks and other types of investments, they still carry different types of risk, including:
Interest rate risk: If interest rates go up, the price of your bond will fall, which can result in a loss if you sell before the bond’s term is up.
Credit risk: When buying corporate bonds, review the company's credit rating. While some bonds may offer higher interest rates, the issuer may be at risk of defaulting on its payments, leaving you at a loss.
Liquidity risk: While you can sell a bond at any time, there may not always be a buyer available. And if interest rates go up significantly, you may be hesitant to sell the bond at a deep discount.
Inflation risk: Depending on the type of bond, you may not get a high enough return to outpace inflation. This is particularly true for short-term Treasury bills.
Because CDs and bonds are fundamentally different, it may be easy to know which one is the right fit for you. If you're unsure, however, here are some scenarios where it makes sense to opt for a CD:
You won't need access to your money until the CD matures
You're concerned about interest rates going down and want to lock in a high rate
You don't want to risk your principal balance
You don't want to spend time researching bonds to find the right fit
You want to avoid the temptation to spend your savings
You have a large purchase coming up at a specific time
You may consider buying bonds instead of putting money in a CD if any of the following is true:
You want to diversify your investment portfolio with safer investments
You want to receive steady income payments
You aren't concerned about the risks associated with bonds
You expect interest rates to go down in the near future