Certificates of Deposit (CDs) have long been foreshadowed as a parapet of security for those looking to safeguard their savings from the tumultuous tides of the market. But is this entirely accurate? While CDs do offer a layer of security compared to stocks or bonds, there are situations where you might lose money by investing in them. But before moving ahead, let’s recap what it was.
What is a Certificate of Deposit (CD)?
A Certificate of Deposit, or CD, is a secure savings vehicle banks and credit unions offer. Unlike standard savings accounts, CDs typically yield higher interest rates in exchange for locking in funds for a predetermined period, known as the term length. Term lengths vary, ranging from a few months to several years.
They are renowned for their safety, largely because they are insured by either the Federal Deposit Insurance Corporation (FDIC) for banks or the National Credit Union Administration (NCUA) for credit unions, up to certain limits. This insurance ensures that your initial investment and accrued interest are protected in case of a bank or credit union failure. In the United States, the FDIC insures deposits up to $250,000 per insured bank, and the NCUA insures deposits up to the same amount per insured credit union.
Having refreshed our brains, let’s dissect the potential downsides of CDs and help you make informed investment decisions.
Early withdrawal penalties
Unlike savings accounts with on-demand access, CDs have a fixed term. Withdrawing your money before the CD matures triggers a penalty, often a significant chunk of your earned interest. This penalty can be pretty hefty, especially for longer-term CDs. A study by the FDIC showed that in 2022, the average penalty for early withdrawal from a CD was around three months of interest. So, if you suspect you need the money sooner, a CD might not be the wisest choice.
Rising interest rates
CDs lock you into a fixed interest rate for the entire term. This can be advantageous in a stable or declining interest rate environment. However, if interest rates rise during your CD’s term, you’ll be stuck with a lower rate, potentially missing out on better returns elsewhere. According to the Federal Reserve, interest rates will increase by 0.5% in 2024. Consider shorter-term CDs or adjustable-rate CDs (if offered by your bank) to mitigate this risk.
Inflation erosion
Inflation refers to the rising cost of goods and services over time. Even though CDs offer a fixed interest rate, they might not always keep pace with inflation. In such scenarios, the purchasing power of your money in the CD decreases over time. In the United States, inflation has hovered around 2.6% in the past year. To combat inflation risk, consider investments with the potential for higher returns, like stocks or real estate (which come with their own set of risks, of course).
Bank Failure (Highly unlikely, but not impossible)
As stated, the Federal Deposit Insurance Corporation (FDIC) insures CDs up to a limit (currently $250,000 per depositor, per insured bank) in case of bank failure. However, exceeding this limit or investing in CDs offered by non-FDIC-insured institutions can put your money at risk. Always ensure your CD is FDIC-insured for maximum protection.
Opportunity cost
By locking your money away in a CD, you forego the chance to invest in potentially higher-yielding opportunities. Stocks, bonds, or even real estate offer the potential for greater returns, although they come with increased risk. The average annual return for the S&P 500 stock market index over the past 10 years is around 10%, significantly higher than the current average CD rates.
Strategies to mitigate risks
If you are interested in investing in CDs, the following tips can help you mitigate risks associated with them:
- CD laddering: It is best to diversify your CD investments by creating a ladder with varying term lengths. This approach provides liquidity while capitalising on higher interest rates offered by longer-term CDs. According to data from Bankrate, as of January 2024, the average APY for a 1-year CD was 0.48%, compared to 0.71% for a 5-year CD.
- Callable CDs: While callable CDs may offer slightly higher interest rates, be cautious of the possibility of early redemption by the issuing bank. Callable CDs introduce additional risk, as the bank can redeem the CD before maturity, potentially disrupting your investment strategy.
- Monitor interest rates: Since investing your money in personal finance, you must stay informed about prevailing interest rates and economic trends. Then, adjust your CD investments accordingly; for instance, when interest rates are rising, opt for shorter-term CDs to capitalise on higher rates.
CDs can be a valuable savings tool, especially for short-term financial goals, as they provide a haven for your money and offer a guaranteed return. But they’re not without drawbacks. That is why experts advise you to carefully consider your investment needs, risk tolerance, and the current economic climate before locking your money into a CD. When you carefully look into the potential downsides, you can make better decisions and choose the investment tool that best aligns with your financial goals.
