CDs vs. Mutual Funds

Certificates of deposit (CDs) and mutual funds offer many of the same advantages—both can be low-risk, low-cost ways of putting some money aside for the future and earning a return in the meantime. However, there are important differences between CDs and mutual funds. In this article, we’ll look at those differences, so you can choose the investment that is right for you.

CDs vs. Mutual Funds: The Key Differences

A certificate of deposit (CD) is a financial product offered by a bank, credit union, or other financial institution. When you purchase a CD, you agree to leave your money there for a certain period of time. In exchange, the financial institution will pay you a set interest rate on the money—one that is typically higher than you'd receive on a checking or savings account. The downside is that your money isn't liquid—you have to leave it in the CD for the whole term you've agreed to or you'll pay hefty penalties.

A mutual fund, in contrast, invests in a diverse pool of securities like stocks, bonds, money market instruments, and other assets. Mutual funds can be either actively managed or passively managed. Actively managed mutual funds are run by professional money managers, who buy and sell securities according to the fund's objectives, such as growth or income. Passively managed funds simply attempt to replicate the performance of a particular index, such as the S&P 500. A mutual fund's performance is measured in terms of its total return.

Because of their diversification, mutual funds offer many of the advantages of investing in securities—potentially high returns, for instance, in the case of stocks—while limiting the risk involved in owning individual securities. However, investors should remember that a mutual fund still involves a certain amount of risk, and some funds are riskier than others, depending on what the fund holds in its portfolio. Mutual funds also charge expenses that can eat into your return.

CDs work in a different way. The institution that issues your CD guarantees you a set rate of interest, no matter what happens in the financial markets. CDs are, in other words, very low risk. This aspect makes CDs suitable for certain kinds of investors or those looking to meet specific financial goals. For example, CDs can make sense for people who have some spare cash that they don't need right now but will need in a few years. That might be because you are planning to buy a home or pay tuition bills in a few years' time. CDs are also suited for very risk-averse investors who just don't want to take their chances in the financial markets.

Let's look at these differences in more detail.

Risk

CDs are some of the safest investments available, in part because you get a guaranteed interest rate. Though there is a risk to the issuer with CDs—if there is a huge stock or bond market crash, for example, it might lose a lot of money—you are protected from this risk.

In addition, the funds you put in your CD are protected by the same federal insurance that covers other deposit products. The Federal Deposit Insurance Corporation (FDIC) provides insurance for most banks and the National Credit Union Administration (NCUA) provides it for most credit unions. When you open a CD with an FDIC-insured or NCUA-insured institution, up to $250,000 of your funds on deposit with that institution are protected by the U.S. government if that institution were to fail.

Mutual funds try to mitigate risk in a different way—through their diversification. But diversification doesn't eliminate risk altogether. A large, generalized stock market crash, for example, will reduce the value of mutual funds that invest in stocks.

In other words, mutual funds can be relatively low-risk, but CDs come with virtually none. This makes CDs suitable for people looking to invest over the short term, where market fluctuations could affect the price of a mutual fund, or long-term investors who just don't trust the markets and want to be as risk-free as possible.

However, CDs do carry one risk that is worth keeping in mind: inflation. Because your money is locked in at a particular interest rate, it could lose purchasing power if inflation heats up after you purchased your CD. This becomes more of a risk the longer the term (maturity date) of your CD is.

Length of investment

CDs have a fixed maturity date, such as six months, a year, or five years. After that, you can cash in your CD and spend the money, use it to buy a new CD, or invest it in some other way. Mutual funds have no maturity date and you can keep your money in one for as long as you'd like.

The risk of a given investment is intimately related to the length of time you hold it. That's also an important factor in choosing between CDs and mutual funds. Because of the inherent volatility of the securities markets, mutual funds are best suited for long-term investors who have the luxury of time. Any short-term drop in the markets—or even a major crash—can become irrelevant if your investment horizon is measured in decades. This is what has made mutual funds a popular retirement investment.

In contrast, CDs are generally best for short-term or medium-term investments: that is, investments of one to five years. But once again, there is nothing wrong with using CDs as a long-term investment tool if you want to build a very low-risk portfolio—you might just have to put up with low returns.

Flexibility

There are two main downsides to CDs. One is that they are very inflexible investment vehicles. You have to leave your money in the CD for the term you've agreed to (unless you have a liquid CD, no-penalty CD, or some other exotic type). Otherwise, you'll probably have to pay a sizable early-withdrawal penalty that could wipe out your returns.

In contrast, mutual funds are relatively flexible. You can generally buy and sell shares in mutual funds as often as you like and cash them out whenever you wish to. You may have to pay a fee for doing so, but it's generally less than the penalties associated with early withdrawals from CDs. 

This flexibility might be attractive if you need to access your money in an emergency. But keep in mind the point above—that mutual funds can lose money as well as make it. You can pull your money out of the fund at any time, but there is no guarantee that it won't have lost money since you bought into it, especially if that was quite recently.

Returns

The second downside to CDs is the relatively low returns they offer. This is a feature they share with other types of low-risk investments. Because the financial institution guarantees that it will pay you a particular interest rate, it doesn't want to offer a higher rate than it has to. If it guarantees too high a rate, and it is unable to generate a sufficient profit by investing your money, it will be stuck with a loss.

Of course, the rate of return on mutual funds is very variable and not guaranteed in any way. Even a low-risk fund might lose much of its value over the course of a few weeks and an economic crisis could adversely affect the value of your shares for years to come. But over the course of several decades, the returns offered by well-diversified mutual funds will in all likelihood exceed those of CDs.

Costs

Finally, keep in mind that mutual funds charge their investors fees, not just once but year after year. Those fees are expressed as the fund's expense ratio, and expense ratios can vary widely from fund to fund. As you can imagine, in years when the fund doesn't make money, these fees only magnify losses. 

In contrast, CDs are a low-cost way of investing. You usually won't have to pay any kind of up-front fee to buy a CD—or any other fees as long as you don't withdraw your money early. There are behind-the-scenes costs associated with maintaining these accounts, of course, but they're already accounted for in the CD's interest rate.

The Bottom Line

CDs are low-risk, low-return investments that are best suited for people looking to save money over the short term or those who want to avoid any kind of risk. Mutual funds offer higher potential returns, along with higher risks, making them best suited for long-term investors who can ride out price fluctuations. If you want to save for retirement some decades from now, mutual funds will be the best pick here. If you want to buy a boat in a few years' time and have most of the money saved up already, consider putting it in a CD.