CDs vs. Mutual Funds: Which is Less Risky During Inflation?

view original post

cd vs mutual fund

Investing is risky, especially amidst international strife and a volatile economy. However, it is possible to mitigate risk while preserving certain levels of return. For example, certificates of deposit (CDs) are low-yield accounts that provide a guaranteed interest rate over a specific time span. On the other hand, mutual funds provide better returns through exposure to the stock market and cut risk through diversification.  A financial advisor can help you determine when to invest in either option to help you achieve your overall financial goals.

What Is a CD?

A certificate of deposit (CD) is an account that holds your money for a fixed amount of time and provides a higher interest rate than most savings or checking accounts. CDs offer timeframes from one month to a decade. Generally, the longer the period and the larger the deposit, the higher your return can be. Usually, you can acquire a CD at your bank or credit union which will all have different options for both the time period and return of the CD.

Pros

Most banks and financial institutions offer CDs, making them widely accessible. Additionally, the Federal Deposit Insurance Corporation (FDIC) insures all CDs up to $250,000, so if your bank goes under, the government will return the account’s dollar value to you. CDs with a credit union are insured by the National Credit Union Administration (NCUA).

CDs provide guaranteed returns, even if the stock market crashes. Therefore, they are risk-free and provide better interest rates than a checking or savings account. And, since you can create a CD with a maturity date or time horizon of a month in the future to a decade, CDs grant flexibility and customization that fit your circumstances.

Cons

While CDs provide safe, steady returns, they have some of the lowest returns among all investment types. Mutual funds, which this article will cover in the next section, offer potentially higher returns, as do 401(k)s and individual retirement accounts (IRAs).

CDs also have early withdrawal penalties, meaning that if you want or need your money before the account matures, you’ll incur fees that may cancel out earned interest. An additional shortcoming of holding your money in a CD is that by locking it away, you prevent it from keeping up with inflation. The longer you keep your money in a CD, the higher the chance your gains may be insufficient to beat inflation.

What Are Mutual Funds?

cd vs mutual fund

A mutual fund is a diversified array of investments in stocks, bonds and other assets. You can set up your mutual fund to mirror a specific stock index’s performance, such as the S&P 500. This kind of mutual fund requires only passive management, potentially lowering costs and simplifying your investment strategy.

Pros

Whether passively or actively managed, mutual funds invest in the stock market and offer the potential for robust returns. Plus, mutual funds mitigate the risk of investing by creating diversified portfolios instead of sinking cash into one or two company’s stocks.

Generally speaking, the longer you invest in the stock market, the better returns you receive. Therefore, if you decide to invest early in your career, your mutual fund has decades to grow, and market downturns won’t affect you as much. 

Cons

Although mutual funds can give higher returns, they also require minimum buy-ins for investors to start. Not every investor has two or three thousand dollars to throw into a mutual fund, so they may have to look into other options, such as CDs or ETFs.

In addition, mutual funds charge fees, especially if a professional actively manages the account. These charges can reduce your overall return. Another factor reducing mutual funds’ profitability is that the FDIC does not insure them. So, if the stock market plunges and the mutual fund dips accordingly, the only way to make up lost ground is to deposit more money or wait for the market to recover.

Additionally, mutual funds aren’t as liquid as a bank account, and you will likely incur fees for withdrawals before retirement age.

CDs vs. Mutual Funds: Key Differences

As we’ve covered above, CDs and mutual funds offer different advantages and disadvantages for growing wealth. Here is a side-by-side comparison of the two to help make your decisions easier.

How CDs and Mutual Funds Compare Metric CDs Mutual Funds Returns Low, fixed returns from financial institutions that beat checking and savings accounts Significantly higher potential returns from stocks, bonds and other assets Risk Virtually no risk of losing your investment Investing in the stock market always presents a chance of losing money Liquidity You can withdraw before account maturity, but you’ll likely nullify your earnings through fees Withdrawing money may incur fees, especially if the mutual funds are in a 401(k) or IRA Insurance FDIC-insured up to $250,000 No insurance; funds are subject to market losses Fees Early withdrawal fees Varying maintenance fees based on management style and possibly early withdrawal fees Other Considerations

While many investors are familiar with different types of mutual funds, not all investors understand the different types of CDs. Maturities and yield are not the only differences among CDs, so when deciding whether to put money in a CD or money market fund understanding the various types of CDs is important. For example, an “add-on CD” is a specialized type of CD that has the same term and withdrawal limits as a standard CD but you you can add to this account over time, while with a normal CD you can only make an initial, lump-sum investment.

A callable CD is an investment that pays more interest and presents more risk than a traditional CD. When you purchase a callable CD, the CD’s issuer (usually a bank or other financial institution) guarantees the investor a higher interest rate in exchange for the option to return the principal and interest to you or “call” the CD before it matures. The call option exists in case market interest rates decrease, allowing the bank to close the CD early and avoid paying investors as high an interest rate.

The Bottom Line

cd vs mutual fund

CDs and mutual funds can enhance your financial strategy and help you reach your financial goals. CDs offer risk-free returns but are low-yield investments that penalize you for withdrawing money early. Mutual funds allow you to invest in the stock market and receive better returns, but they introduce more risk. CDs and mutual funds are not an either-or proposition. They likely both have a place in your investment strategy since they provide different benefits and time horizons. CDs can provide secure gains in the short term, while mutual funds can be foundational to your retirement plan.

Tips for Investing

  • Balancing your investment between CDs and mutual funds can be challenging. A financial advisor can guide you through major financial decisions, like determining your investing strategy. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.

  • Weighing options for investing in CDs and mutual funds depends on return rate, time horizon and more. SmartAsset’s investment calculator can help you estimate how much your money will grow to help you decide which type of investment is right for you.

©iStock.com/Morsa Images, ©iStock.com/staticnak1983, ©iStock.com/undefined undefined

The post CDs vs. Mutual Funds: Key Differences appeared first on SmartAsset Blog.

Related Posts