Certificates of deposit (CDs) are a low-risk way to invest. The bank or credit union where you open the CD will pay you an interest rate that is typically higher than other types of savings accounts. The trade-off is that you have to leave your money in the CD for the whole term you've agreed to or pay a hefty penalty.

This model makes CDs most suitable for certain financial objectives or certain types of investors. For example, if you've saved some money that you plan to spend or invest in a few years, putting it in a CD can be a safe way to earn a little interest in the meantime. Alternatively, you might be a very cautious investor who simply doesn't trust the stock market. In that case, you can use CDs to invest over the long term. You'll just have to put up with their relatively low rates of return.

The Best Uses of CDs vs. Other Investments

The primary advantage of CDs is the very low level of risk they carry. When you get a CD, the bank or credit union guarantees that you will earn a set rate of return on your money.

Most CDs are also protected by the same federal insurance that covers other deposit products. The Federal Deposit Insurance Corporation (FDIC) provides insurance for most banks, while the National Credit Union Administration (NCUA) provides it for most credit unions. When you open a CD with an FDIC- or NCUA-insured institution, up to $250,000 of your money on deposit with that institution will be covered.

These two features make a certificate of deposit one of the safest investments around. The downside is that CDs offer only modest returns. While the interest rate on CDs can vary widely from one financial institution to another, even the best rate will likely be lower than the return you could reasonably expect from other forms of investment, especially over the long haul.

Let's look at two situations where CDs may make the most sense.

Using a CD for Short-Term Savings

As mentioned earlier, a CD can be a convenient place to park some money for a few months or a few years, with virtually no risk of losing any of your principal. For example, if you're saving up for a new car or a down payment on a home, you can buy a CD with a term that's in line with when you expect to need the money. You'll also get a better return than you would on a savings or money market account.

Investing your money in the stock market might generate a larger return, but it's risky, especially over the short term. If you need your money back in six months, for example, any stock you've invested in could very well have lost value.

All that said, investing in a CD only makes sense if you're sure you'll be able to keep your money in it until it reaches maturity. While there are some types of CDs that allow you to take out money before then, such as liquid CDs, most charge substantial early withdrawal penalties. In many cases, you'll lose all of the interest you've earned, and you may even lose some of the money you put into the CD in the first place.

Using CDs as a Long-Term Investment

It's also possible to use a CD as a long-term investment and plenty of people do. If you want to avoid the risk and volatility of the stock and bond markets altogether, putting your money (or a portion of it) in a CD will provide a guaranteed positive return. Though CDs don't offer the growth potential of stock and bond investments, they also don't carry the risk of downturns. For money that you want to keep safe and grow at a predictable, if unspectacular, pace, certificates of deposit can fit the bill.

Bear in mind, however, that while CDs are immune to most types of risk, they are still at risk of inflation. Even though your money will be growing in dollar terms, it could be losing purchasing power if the inflation rate is higher than your CD's interest rate. This is more of a danger the longer the term of your CD is. Compensating for that risk is one reason that longer-term CDs pay a higher interest rate than those with shorter terms.

CDs can also be an easy way to invest for the long term. You generally don't need to do anything if you want to leave your money in a CD once your existing CD reaches maturity. In the month or two leading up to your CD's maturity date, the bank or credit union will notify you of the impending end date. If you don't provide instructions to the contrary, the financial institution will typically roll over proceeds into a new CD with a term similar to your previous one. For example, a five-year CD would be replaced with a new five-year one, paying whatever the current interest rate is on a CD with that term.   You can also arrange for your CD to automatically renew when you first sign up.

The Bottom Line

Certificates of deposit are among the safest investments around. While they pay a higher rate of interest than some other safe investments, they also lock your money in for a period of time and you'll usually have to pay an early withdrawal penalty if you need it sooner. Because of those features, CDs tend to be best for short-term investors (with a good idea of when they'll need their money back) or long-term investors (who don't mind CDs' relatively low returns compared with riskier investments).