A certificate of deposit is an interest-bearing, FDIC-insured investment. The risks and returns of certificates of deposit are on the low end of the spectrum compared with other investment options, but that doesn’t mean that CDs are risk-free assets. You should be aware of the types of penalties and risks that could affect your CD rates and APY before you invest.
On the return side of the ledger, CDs generally don’t pay a high rate of interest, but the rate you do get heavily depends on the type of CD you purchase.
Risks of Certificates of Deposit
Like most financial products, CDs do carry some degree of risk. Although your principal and interest are insured by the Federal Deposit Insurance Corporation, CD risk does exist. Evaluate your certificate of deposit risk level by taking a look at some of these CD properties:
- Early Withdrawal Penalty: If you take your money out before the CD matures, you’ll likely be subject to some penalty fees which can diminish your return and, in some cases, even your principal.
- Reinvestment Risk: If interest rates go down and your high-interest CD account matures, you might have to roll it over at the lower rate.
- Inflation Risk: If the rate of inflation exceeds the interest rate on your CD, you’ll have less purchasing power than when you get your money back.
- Limited Insurance: If you buy CDs at a premium in the secondary market — meaning that you buy them from a broker and pay more than face value — that additional amount is not covered by FDIC insurance. And although FDIC insurance limits are high at $250,000 per account, the entire amount will not be covered if you buy a CD of greater than that value.
Potential Returns of CDs
Although a CD is a low-risk investment by design, it can still help you build your financial worth. Here are some CD characteristics — and CD strategies — that can help you earn the best CD rates and boost your CD returns:
- Higher Interest Rates: CD rates are typically higher than regular savings account rates. CD rates are also predictable and this can enable you to plan ahead.
- Rate Increase: If you buy a CD with a rate-increase option, you can usually switch to a better rate when it becomes available. The number of times you can exercise this option varies among financial institutions, and it typically depends on your CD’s term.
- No-Penalty Option: If you choose a no-penalty CD, you can withdraw all your funds — including the interest you’ve earned — without any early withdrawal penalty.
- Compounding: Annual percentage yields can end up being higher than the certificate of deposit interest rates if you reinvest your interest payments, making your total CD return rates higher.
Learn More: Things to Know About High-Yield CDs
Weigh the Risk vs. Return Potential Before Investing in CDs
Although CDs are safe investments, they do carry some risk. You can usually earn higher interest rates from a CD than a savings account as a result. They are not entirely liquid, however, so if you think you might need access to your funds before the maturity date of your CD, you might be better off in a savings account so you can avoid early withdrawal penalties.
Speak with a financial advisor and have him walk you through all the details and compare CD rates before you commit to a CD investment. Then you can decide for yourself what level of risk you’re comfortable carrying in exchange for your CD interest rates.
Barri Segal contributed to the reporting for this article.