CDs vs. Mutual Funds

If you're saving money for the future, certificates of deposit (CDs) and mutual funds are two of the main choices you have to consider. Certificates of deposit offer a very modest but guaranteed return and carry virtually no risk. Mutual funds come in a bewildering variety, but all are subject to some extent to the ups and downs of the markets.

You could think of them as serving two distinct purposes:

• CDs are good for building up a fund for a short-term goal, like a down payment on a car. Your money is earning a tad over the rate of inflation, at best, but you'll never earn less or lose principal.
• Mutual funds are better for building wealth over the long term. The markets have their ups and downs but over time the trend is upwards.

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 keep your money invested in it for a certain period of time.

In exchange, the financial institution will pay you a set interest rate on the money; the longer the term, the higher the interest paid. The rates are not generous but they're better than what you'd get on a regular 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 that can erase your gains and even eat into the principal invested.

Mutual Fund Investing

A mutual fund is a pool of money collected from many investors that may invest in a wide array of stocks, bonds, money market instruments, and other assets. A huge variety of mutual funds is available. Many specialize in particular sectors like technology or energy. Some focus on fast-growing stocks or blue-chip staples.

Mutual funds can be purchased either directly from a sponsoring company, such as Vanguard or Fidelity Investments, or through a broker.

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 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 over a quarter, a year, or several years.

Risks of Mutual Funds

Mutual funds are diversified practically by definition. That is, each contains a number of investments, limiting the impact of heavy losses.

But some mutual funds are riskier than others. A mutual fund that concentrates on real estate investments may soar during a bubble and then lose money when the real estate market slows. A fund that focuses on blue-chip stocks or Triple-A-rated bonds may not have spectacular returns but probably won't suffer severe losses either.

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.

Mutual funds also charge expenses that can eat into your return. The lowest expense charges can be found in passively managed mutual funds.

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.

CDs vs. Mutual Funds: The Risks

CDs are among the safest investments available. You get a guaranteed interest rate.

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.

How Mutual Funds Reduce Risk

Mutual funds aren't insured. However, their managers try to mitigate risk in a different way—through 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 and avoid any loss of principal, and for long-term investors who just don't trust the markets.

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.

What's Your Investment Timeline?

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.

Your timeline for investing is critical to your assessment of risk. Because of the inherent volatility of the stock markets, mutual funds are best suited for long-term investors who can wait out a downturn. Even a major crash can become irrelevant if your investment horizon is measured in decades. That's why mutual funds are a popular retirement investment.

CDs are better suited for short-term or medium-term investments of one to five years. If you're saving to buy your first home, you don't want to risk your principal.

How Flexibility Can You Be?

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 wipes 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 can be important if you need to access your money in an emergency. But keep in mind 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's no guarantee that it won't have lost money since you bought into it.

Weighing Risk vs. Return

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.

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 months or even years to come.

But over the course of several decades, the returns offered by any well-diversified mutual fund will probably exceed those of CDs.

Check the Fees

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 magnify your losses. 

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 risk.

Mutual funds offer higher potential returns, along with higher risks. They're suitable 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. 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.