CDs vs. ETFs: What's the Difference?

CDs vs. ETFs: An Overview

Certificates of deposit (CDs) and exchange-traded funds (ETFs) are two popular investment options. Both allow you to save some of that extra cash aside while promising you a modest return. They are considered to be low-risk investment vehicles, which means you won't be making a big gamble with your money, and both are easy to acquire in your portfolio.

But, there are some inherent differences between these two investment options, including the level of risk associated with each. CDs offer a guaranteed return while ETFs are susceptible to asset price fluctuations. This makes ETFs riskier than CDs, especially over the short term. Keep in mind, though, that ETFs offer investors more flexibility and higher returns than CDs over the long run.

In this article, we’ll look at the key differences between CDs and ETFs, so you can choose the investment that is right for you.

CDs

A certificate of deposit is a financial product offered by a bank or financial institution, such as a credit union. When you take out a CD, you agree to leave your money in one place for a set period of time.

The issuer of your CD will pay you a set interest rate on this money—one that is typically higher than other types of savings accounts. This return is set and guaranteed, regardless of what happens to the stock market. This makes them very low risk. So if you set aside $1,000 in a one-year CD and the bank promises you a 2.5% return upon maturity, that won't change even if the market tanks.

Having said that, it's important to note that CDs tend to offer relatively low returns. This is a feature they share with other types of safe investments. Banks use the money from CDs to loan out to others. And because the bank guarantees a particular interest rate, they don’t want to make this too high. If they do, and they can’t generate that level of return by investing your money in other ways, they will lose money.

This aspect makes CDs suitable for very risk-averse investors or those looking to meet specific financial goals. CDs are good for people who have some spare cash that they don’t need right now but will need in a few years.

ETFs

An exchange-traded fund is a type of pooled investment security that operates much like a mutual fund. Unlike the shares of a mutual fund, ETF shares can be purchased or sold on a stock exchange the same way that a regular stock can.

ETFs are popular investments for people looking for relatively low-risk, low-cost investments. They offer exposure to the stock market, but most are inherently well-diversified. This means they can offer higher rates of return than a CD. Investors should remember that investing in an ETF is still investing in volatile assets and so is inherently risky.

These funds can be structured to track anything. They typically track a particular index, sector, commodity, or other asset. This can be an individual asset or a large and diverse collection or basket of securities. ETFs can even be structured to track specific investment strategies.

The rate of return offered by ETFs can be quite variable and not guaranteed in any way. Even a low-risk fund might lose much of its value over a few weeks and an economic crisis could adversely affect the value of your shares in the fund for a decade or more. But over several decades, the returns offered by a well-diversified stock portfolio are expected to exceed those of CDs.

Key Differences

Risk

CDs are among the safest investments on the market because you get a guaranteed interest rate—no matter what market conditions prevail. Banks that offer CDs may take a hit if the market crashes, but you are still protected by the Federal Deposit Insurance Corporation (FDIC) and the National Credit Union Administration (NCUA).

Most ETFs try to mitigate risk differently by diversifying their holdings. ETFs have historically been designed to track a particular index or sector and are generally passively managed to ensure they track their associated index closely. This makes them far less risky than investing in individual stocks. Keep in mind that this doesn’t eliminate the risk altogether.

In other words, ETFs are relatively low risk in comparison to other ways of putting your money into the stock market, but CDs come with virtually no risk at all. This makes CDs suitable for people looking to invest over the short term, where stock market fluctuations could affect the price of a stock portfolio or ETF, or long-term investors who just don’t trust the stock market and want to be as risk-free as possible.

Investment Time Horizon

The risk of a given investment is related to the length of time you hold it. Well-diversified ETFs (and stock portfolios) are considered to be relatively low-risk over the long term because the stock market tends to increase in value.

However, if you are only looking to invest for a few years, a stock market crash (or even a drop in a particular economic sector) can easily wipe out the value of your investment. This makes ETFs a relatively risky choice for short-term investment.

In contrast, CDs are good for short- to medium-term investments. These are investments that last from a few months to 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. The downside is that 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. Unless you have a no-penalty CD, you have to leave your money in the CD for the agreed-upon term. Otherwise, you’ll probably have to pay sizable early withdrawal penalties that could wipe out your returns.

ETFs, on the other hand, are relatively flexible. This means you can trade ETF shares as often and cash them out whenever you like. You may have to pay a commission or 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 the money you’ve invested in an emergency. But keep in mind that if you invest in ETFs, there's a potential for loss in addition to making gains. You can pull your money out of the ETF at any time, but there is no guarantee that you won’t lose out since buying your shares, especially if that was quite recently.

The Bottom Line

Though both CDs and ETFs appear to offer a low-risk, low-cost way to invest your money, there are important differences between them. CDs are low-risk, short-term, low-return investments that are suited for people who want to save over the short or mid-term, or those who want to avoid any kind of risk.

ETFs offer both higher risk and (potentially) higher returns for long-term investors who can ride out price fluctuations. If you want to save for retirement, ETFs are the best pick here. If you need the funds soon but have the money to invest now, a CD would likely be a better choice.