Tuesday, 14 May 2024

Think CDs Are a Risk-Free Investment? Here Are 3 Reasons Why You’re Wrong

by BD Banks

<div>Think CDs Are a Risk-Free Investment? Here Are 3 Reasons Why You're Wrong</div>

Image source: Getty Images

When you’re looking into investment options, certificates of deposit (CDs) can seem like a pretty risk-free investment. After all, they are FDIC-insured so your investment (up to $250,000) is protected against bank failures. And the rate of return you earn is also guaranteed, so you’ll know upfront exactly how much your return on investment will be.

The reality, though, is that while CDs are fairly safe, there are still risks associated with investing in them. In fact, here are three reasons why it’s wrong to assume you can’t lose with a certificate of deposit.

1. You could lose money if you have to take the funds out too early

The biggest risk you face when you put money into a CD is that you’ll be penalized if you must break the CD early. See, you have to commit not to withdraw your invested funds until the CD term matures. Depending what term length you choose, this could take as little as a few months or as long as five years.

Penalties vary by bank and by CD, but typically amount to around 90 to 365 days of simple interest. This can add up to a big penalty. And it’s possible you’ll not just lose gains, but also some of the principal you invested. This can happen if you have to make a withdrawal before earning enough interest to cover the fees.

Now, you may believe this won’t happen to you since you don’t plan to break the CD term early. But no one can predict the future, and circumstances may arise that make pulling out your funds early necessary. So, you need to take this risk under consideration before you decide a CD is right for you.

2. You could lose ground due to inflation

There’s another big risk to think about as well. When you put your money into a CD, your rate is guaranteed for the duration of the term. This is a good thing if interest rates go down. It’s a bad thing if interest rates go up and you’re stuck with a CD that’s not paying you much.

You’ll not only miss out on higher potential gains if this happens to you, but you could also effectively lose ground if you are stuck in a CD that’s paying less than the rate of inflation. If you bought a 5-year CD in January of 2022, odds are your rate would have been around 1.00% or less. In 2022, the inflation rate ended up being 8.00%.

If you were earning 1.00% while prices were going up 8.00%, your invested money was losing buying power. Now, this is a pretty extreme example, but it’s absolutely not unheard of for inflation to outpace CD rates to some degree. It’s a risk you need to consider before opening one.

3. There’s an opportunity cost of tying your money up in a CD

The final risk you should think about is the risk associated with being too conservative with your investments. CDs cap your rate well below what the stock market can offer, even at today’s current high rates.

If you are tempted by the safety CDs provide and you put money into them that could instead go into the market, you risk severely limiting the returns you can earn and thus the wealth you can build. You don’t want to do that, so you should not put money into CDs if it’s money you can leave invested for more than five years. Using a brokerage account to buy shares of an S&P 500 index fund is a better option.

You need to consider these risks before you open a CD. If you decide they’re worth taking, check out The Ascent’s guide to the best CD rates right now. If you decide that you’d rather put your money elsewhere, you can check out this guide to the five best places to put your money in 2024.

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