Cash News
Certificates of deposit (CDs) are a popular type of deposit account for savers looking to protect their money from market risk and inflation. CDs allow you to deposit money at a fixed interest rate for a specific period and often come with higher rates than many savings accounts.
CDs are considered low-risk because the interest rate is fixed for the entire term, and the principal balance can’t lose money — in most cases. That said, CDs can lose money in certain rare situations. So before you put your money in a CD, learn the risks and how to protect your funds.
Read more: The best CD rates on the market today
While CDs are considered low-risk investments, there are certain factors that can negatively impact your returns.
The biggest potential risk to your CD balance is fees. CDs typically come with early withdrawal penalties to keep account holders from dipping into their funds before maturity. These penalties can significantly reduce your overall return. In fact, if you haven’t earned enough interest to cover the early withdrawal penalty, you could lose a portion of your principal balance.
If this is a concern, consider opening a no-penalty CD, which is offered by some financial institutions. The tradeoff is that you may have to accept a lower interest rate. Alternatively, choose a shorter CD term so there’s less chance that you’ll need to access the funds before the CD matures.
A bank failure happens when a bank is closed by a federal or state regulatory agency because it’s unable to meet its financial obligations to depositors, creditors, and others. Even though this situation is pretty rare, it’s important to open a CD with a bank that’s insured by the Federal Deposit Insurance Corporation (FDIC) — or in the case of a credit union, the National Credit Union Administration (NCUA).
These government entities back up to $250,000 in deposits per institution, per account holder, per ownership category. If your CD is not held at a federally insured institution, you may not be able to retrieve your CD funds in the event of a bank collapse.
Read more: How to insure deposits over $250,000
There are some types of CDs that come with higher risk and may lose money, depending on the situation. Brokered CDs, for example, are purchased through brokerage firms or from individual brokers rather than traditional banks or credit unions.
Brokered CDs do offer the potential to earn higher interest than regular CDs. Plus, you can sell brokered CDs before they reach maturity without incurring a penalty.
However, brokered CDs carry more risk than traditional CDs, partly because some brokers may not be properly licensed or certified. Additionally, brokered CDs are more complex and come with higher fees, which can make it harder to maximize their full earning potential. And if you decide to sell your CD, you could end up taking a loss since the market value of brokered CDs fluctuates.
CDs allow you to achieve higher interest rates and lock in those rates for the entire term, regardless of market fluctuations. The downside is that you could miss out on better returns if rates increase while your money is tied up.
Technically, changing rates won’t cause your CD to lose money. But there is an opportunity cost to locking in your funds when rates are expected to rise (which isn’t a concern today, but could be in the future). This means you have to weigh the benefits of locking in a certain rate now versus the risk of losing out on potentially higher rates during the CD’s term.
One way to hedge against rising rates is by choosing a step-up CD or bump-up CD, which allow you to increase your rate during the CD’s term. Again, however, the interest rates on these specialty CDs are often much lower than traditional CDs, so you may not come out ahead even if you secure a rate increase.
Inflation is the rate at which the cost of goods and services rises over time. Inflation impacts not only how much you spend but also the value of your dollars.
When the inflation rate surpasses the interest rate on your CD, the real value of your return decreases. Again, you don’t technically lose money in a CD in this situation. But when the CD matures, the money you get back will have less purchasing power than when you first invested it.
While CDs are one of the safest places to put your savings, no investment is totally foolproof. Consider these steps you can take to protect your CD funds:
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Make sure your money is insured: Federal insurance provides an added layer of protection in the event that your bank fails. You can easily verify whether your financial institution is protected by using the BankFind or Find a Credit Union tools.
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Keep your deposits within federal coverage limits: If you have deposits over $250,000, it’s a good idea to spread that money across multiple financial institutions so you remain under federal coverage limits. Another option is to take advantage of the Certificate of Deposit Account Registry Service (CDARS). By participating in the CDARS program, you can have more than the FDIC insurance limit insured by distributing your funds into CDs across a network of banks without having to manage multiple bank accounts yourself.
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Choose a CD term that aligns with your goals: Early withdrawals from CDs can impact your overall returns because of the fees involved. So before you open a CD, think carefully about your short-and long-term savings goals, and choose a CD term that matches your needs to avoid dipping into funds too soon.
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Try a CD ladder: Creating a CD ladder is a strategy where you split your funds into several CD accounts with varying terms and rates. This allows you to maintain some liquidity as shorter-term CDs mature while still taking advantage of the higher rates that come with longer-term CDs.