Risk of Certificates of Deposit
Certificates of deposit are widely regarded as a low-risk investments because they offer a fixed interest rate and -- if your CDs are held at a bank -- they're covered by the Federal Deposit Insurance Corporation. However, that doesn't mean that there aren't a few risks the come along with investing in CDs.
Rising Interest Rates
Most CDs keep the same interest rate for entire term, regardless of how market rates change. This is great if market rates drop because the bank still has to pay you the higher interest rate. However, if interest rates rise, you're stuck getting paid the lower interest rate. Plus, there's always the chance that the interest rate won't keep up with inflation. It's possible to get a CD that allows you to adjust the interest rate to the market rate once during the term, called a "bump-up CD," but these usually have a lower rate to start.
The reason CDs pay a higher interest rate than other deposit accounts, like savings accounts, is because of your promise to leave the money in the CD until it matures. If an emergency strikes and you take the money out early, you have to pay early withdrawal penalties, which can be quite large. According to Bankrate.com, the average penalty is three months' worth of interest for CDs with terms of under one year, and six months' worth of interest for longer-term CDs. Plus, if you haven't earned that much interest yet, banks may dip into your principal to pay the penalty.
Some CDs have a call feature, which allows the bank to require you to cash it in after a certain period of time. For example, a callable CD might mature in five years, but be callable after just one. This means that you can't cash it in without penalty for five years, but if the bank decides it no longer likes the terms, such as if market interest rates plummet, it can cash you out after just one year.
For most people, bank failure isn't a risk with CDs because the FDIC covers your deposit accounts at any member bank for up to $250,000. So, as long as your CD is under that limit, even if the bank goes under, your money is still safe. However, if you've invested more than $250,000 at a single bank in CDs, and the bank goes under, only the first quarter million is protected.
Based in the Kansas City area, Mike specializes in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."