How Risky Are Certificates of Deposit?

CDs are a great way to manage cash in a very safe, flexible way. To make them even more useful, try staggered, short-term maturities. CDs also have a role in both taxable and tax-sheltered accounts.
By Charles Epstein
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certificate-of-deposit

Bank deposit accounts such as certificates of deposit (CDs) are often referred to as "risk-free" investments. Commonly issued by banks, credit unions, and financial institutions, they are appropriate investments for people who want their cash to work for them for a specific, short period with minimal risk.

A certificate of deposit (CD) is a contract between the CD purchaser and the issuer. The purchaser deposits money for a certain period of time and, in exchange, the issuer agrees to return the principal plus interest at the end of the contract's term.

It sounds straightforward, and it is 99% of the time.

But while CDs are considered "safe" investments, there are conditions under which they may incur some form of risk. Of course, investors can take steps to mitigate risk and avoid problems - if they know what to look for. Managed correctly, people can benefit from keeping some money in CDs.

This article explains not only the types of risk investors can encounter, but also how to…

  • maximize return on CDs
  • prevent and mitigate CD risks

Compare current CD rates

Certificates of Deposit: Are CDs Risky?

There's no getting around risk. CD risk and return is generally at the very low end of the spectrum, but it's best not to assume you are immune to risk when you invest in CDs.

The better course of action is to recognize potential risks so you can manage them. That means learning about the different types of CD risk and figuring out how to mitigate them.

 

 

Types of CD Risk

Investments face a variety of risks, but those that apply to certificates of deposit are fairly easy to mitigate and avoid if you know how. Here are the major types of CD risk you would want to address:

  • Interest rate risk

    The danger that rates will rise after the CD is purchased, meaning the investor loses the opportunity to make more money as rates rise.

  • Inflation risk

    This is the risk that rising inflation could erode the value of your CDs or erase your return.

  • Bank failure

    The possibility that the bank or credit union issuing the CD will fail.

  • Hybrid CD risk

    Certain CD returns are based on an index that follows the stock market.

  • Tax risk

    This risk happens when the investor fails to prepare cash flow to pay tax obligations.

  • Liquidity risk

    This occurs when the investor needs the cash to be returned before the CD matures.

Strategy: How to Mitigate CD Risk

There are four activities you can do that would help you protect yourself against CD risks. They are:

  1. Shopping

    Actively looking for the best CD rates (using rate consistency as a guide), comparing CD rates against inflation, and shopping for fees

  2. Protecting

    Verifying FDIC/NCUA deposit insurance, staying on top of economic cycles and news

  3. Structuring

    Creating a CD ladder

  4. Planning

    Maintaining a budget, managing cash flow needs

Here's how these activities can be applied to help you protect against loss of value in a CD:

Type of RiskShoppingProtectingStructuringPlanning
Interest Rate RiskAmerica's Best Rates CDCD LadderBudget
Inflation RiskCD CalculatorEconomic NewsCD Ladder
Bank FailureAmerica's Best Rates CDFDIC/NCUACD Ladder
Hybrid CD RiskFeesEconomic NewsCD Ladder
Tax RiskBudget
Liquidity RiskFeesCD LadderBudget

Interest rate risk

The biggest risk people face when investing in CDs is that interest rates fluctuate all the time - and that could keep you locked into a lower rate on your CD investment as rates rise in the future.

The main ways to protect against interest rate risk are by shopping for the best CD rates and lowest fees, and also by comparing CD rates with a CD calculator. In addition, you would want to make sure you budget properly and manage your cash flow tightly. That can help you structure your CD ladder most effectively.

How to Mitigate Interest Rate RiskActivityResource
ShoppingShop for the best CD ratesAmerica's Best Rates CD
Shop for the lowest feesNo-Penalty CD - How Does It Work?
Use a CD calculator to compare ratesCD calculator
PlanningCreate a budgetHow to Make a Budget - Step by Step
Manage cash flowThe Most Cash You Can Withdraw At Once
StructuringCreate a CD ladder5 Moves to Optimize Your CD Ladder

Inflation risk

Inflation can dramatically impact the value of your investments over time. Even in an era of mild inflation, the steady accumulation of price increases over a period of years can have a profound effect on how much money you'll have to spend in the years to come.

To counteract inflation risk, investors should use a CD calculator to compare current CD rates under different inflation scenarios. It's also important to stay abreast of economic cycles and news as it develops.

Learning how the Federal Open Market Committee works can really help consumers formulate a solid financial strategy which, again, can help determine how to structure a CD ladder.

How to Mitigate Inflation RiskActivityResource
ShoppingUse a CD calculator to compare ratesCD calculator
ProtectingStay on top of economic cycles and newsLatest FOMC meeting
StructuringCreate a CD ladder5 Moves to Optimize Your CD Ladder

Bank failure

Another remote risk is that the bank or credit union that issued the CD fails.

The best way to prevent the risk of a bank failure from affecting your CD investment is to make sure the CD is issued by an FDIC-insured bank. With deposit insurance in place, there is a very low probability that the financial institution that issued the CD will fail.

For example, in 2020, there were only two bank failures; and in 2019, there were four failures according to the FDIC list of bank failures.

An investor should only purchase a CD from a bank that carries FDIC insurance or a credit union that is insured by the NCUA. In the rare instance that a bank fails, your CD is insured up to $250,000 per depositor, per institution.

If your investment in CDs exceeds $250,000 in a single bank, make the other CD purchases in different financial institution.

How to Mitigate Risk of Bank FailureActivityResource
ShoppingShop for the best CD ratesAmerica's Best Rates CD
ProtectingVerify FDIC / NCUA deposit insuranceLook for the FDIC / NCUA logo on website
Stay on top of economic cycles and newsLatest FOMC meeting
StructuringCreate a CD ladder (at different banks)5 Moves to Optimize Your CD Ladder

 

FDIC sign

It's also advisable to stay abreast of economic news to know when conditions point to the likelihood of bank failures.

Multiple account owners and beneficiaries

When CDs have multiple owners or beneficiaries, things can get a bit complicated when it comes to FDIC insurance coverage.

For example, a joint account receives $250,000 in coverage for each owner. So, if you and your spouse have a joint account, the insurance coverage for that account could be as much as $500,000. Just remember that if either of you has another account at the same bank, the value of that account will cut into your coverage on the joint account.

If you have a trust account, the $250,000 limit may apply to each of the trust's beneficiaries. However, this depends on how the trust is set up, so check before you assume you have enough coverage.

A useful tool for checking on FDIC coverage is the Electronic Deposit Insurance Estimator (EDIE) offered by the FDIC. The tool takes you through a series of steps to enter specific information about your accounts so you can receive a report on your FDIC coverage.

Hybrid CD risk

There are plain vanilla CDs that pay a flat interest rate and have a specific maturity date, and then there are a few hybrids that have other enticements and risks for investors.

First, there is a market-linked CD whose return is linked to a basket of stocks or a market index, such as the S&P 500. These also are called an index-linked CD, an equity-linked CD, or a market-linked CD.

These types of CDs may seem enticing at first glance, but they carry some risks. Among the biggest are fees for early redemption, taxable returns that are treated as interest rather than as capital gains, and limits on gains. Combined, these fees and penalties mean these types of CDs often underperform their plain-vanilla counterparts.

There is also a special category of CDs that are callable.

Like a regular CD, a callable CD pays a fixed interest rate over its maturity period, but the bank issuer holds a call option on the CD and can redeem, or "call," the CD for the full amount before it matures. Callable CDs carry a higher interest rate than a regular non-callable one because the issuer has to compensate the investor for the risk that the CD will not reach its maturity date. The call dates are all spelled out in the fine print.

Jumbo CDs usually require an investment greater than $50,000. However, they do not always pay a higher rate of interest than a CD in a smaller denomination. It pays to read the fine print. You may be better off using a laddering strategy if you have this much to invest.

How to Mitigate Hybrid CD RiskActivityResource
ShoppingShop for the lowest feesNo-Penalty CD - How Does It Work?
ProtectingStay on top of economic cycles and newsLatest FOMC meeting
StructuringCreate a CD ladder5 Moves to Optimize Your CD Ladder

Tax risk

Then there are taxes. CD purchasers may be surprised to learn they will owe taxes on the earned interest even though the CD has not matured.

This tax obligation means CD holders must have the cash available to pay the taxes when they become due, even before the CD matures.

When the CD matures, the yield is taxed at a higher rate at the state and federal levels. This amount is taxed as interest income, not at the (usually) more favorable capital gains rate.

Taxes are due the year in which the interest was paid. When the CD is purchased from a bank or credit union, the owner gets a 1099-INT statement stating how much interest was earned in that year. On CDs that mature in a few years, the tax is due in the year it was earned.

Avoiding tax risk is a matter of making a budget and managing cash properly so the necessary funds are available at the proper time when the tax obligation becomes due.

How to Mitigate CD Tax RiskActivityResource
PlanningCreate a budgetHow to Make a Budget - Step by Step
Manage cash flowThe Most Cash You Can Withdraw At Once

Liquidity risk

Liquidity risk can happen when there is a mismatch between when an investor needs money and when that money becomes available, such as with a 5-year CD. It's also called "withdrawal risk," referring to the early withdrawal penalty that would apply because the investor needs the cash returned before the CD matures.

In this case, the penalties can be severe. But, just as CD rates are competitive, so are the penalties for making an early withdrawal. Investors should make sure they know the early withdrawal penalty before they purchase a CD. The best combination when buying a CD is to get the best interest rate possible accompanied by paying a small penalty for early withdrawal.

Other ways to mitigate liquidity risk are to maintain a budget and manage your finances carefully. By creating a CD ladder, investors can help protect against the need for an unexpected distribution because of an emergency or the like.

How to Mitigate CD Liquidity RiskActivityResource
ShoppingShop for the lowest feesNo-Penalty CD - How Does It Work?
PlanningCreate a budgetHow to Make a Budget - Step by Step
Manage cash flowThe Most Cash You Can Withdraw At Once
StructuringCreate a CD ladder5 Moves to Optimize Your CD Ladder

Strategy: How to Create a CD Ladder

A common strategy that can help mitigate most of the risks of CDs is to create a CD ladder.

Laddering is a straightforward process where a CD investor who has $30,000 to invest, for example, buys CDs with lengthening maturities.

With interest rates at historic lows, they can only go higher or remain the same. If the investor thinks rates will rise, they could buy $10,000 in one-year, $10,000 in two-year, and $10,000 in five-year CDs. As the CDs mature, the investor rolls the proceeds into new CDs to capture any rate increases.

If you don't want to manage these rollovers yourself, some fund companies will do this for you by investing in mutual funds that invest in short-term instruments with staggered maturities. Some ETFs also offer this same feature.

Don't forget, though, that, even as the CDs are maturing, you have to pay taxes that are due on the earned interest.

The potential difficulty is that as you build your ladder with multiple accounts, and as those accounts accumulate interest over time, you may lose sight of the fact that it is the combined value of these accounts, and not each account individually, that counts toward the $250,000 FDIC insurance limit.

The best tip for dealing with this is that once the total value of your CDs at one bank starts to exceed $200,000 or so, look to open your next CDs at a different bank. After all, a CD ladder can work equally effectively at one bank or at multiple banks. The side benefit of spreading your ladder among multiple banks is that you may take time to shop for the best rate available when you start or roll over each CD in a ladder.

Finding the Best CD Rates

Finding the highest paying CD for the time period you are interested in is easier than ever thanks to online bank CD comparisons and the America's Best Rates Survey.

The unique survey identifies the best CD rates for 1-year CDs and 5-year CDs that have been offered over the quarter. Better than simply identifying and reporting the best CD rates on a given date, the America's Best Rates Survey shows which banks offer the highest paying CD rates consistently over an entire quarter.

Rate consistency is the clearest measure of which banks actually compete for your CD business.

The rate consistency standard is not only difficult to achieve, but the banks that appear on the top ten list in the America's Best Survey tend to stay among the group of leading banks for CDs year after year.

Key CD Terms

Yield to maturity

The yield to maturity is the percentage rate of return for a CD assuming the investor holds the asset until the maturity date.

Realized yield

In a CD, this is the actual return earned during the holding period for an investment that includes the interest payment.

Annual Percentage Yield (APY)

The APY is the real rate of return earned on a CD that accounts for the effect of compounding interest.

FAQs

Most major banks, credit unions, or investment firms offer CDs. Buying the CD is simple and only requires the completion of some forms. It is even easier if you have an existing relationship with a financial institution and your money is already held in an account.

Investors should have a re-investment strategy in place to keep their cash working for them. When the CD expires, you will be issued a check for the principal, plus any accrued interest. You can then re-invest it in a new CD or apply it to a new purchase, down payment, tuition, or whatever your goal was when you bought the CD.

There is no escaping taxes. Taxes are due on the interest earned on the CD the year in which interest was paid. The CD issuer will issue an IRS 1099-INT statement to the CD owner.

Yes, they have a role in both. The main difference is in how you want the tax obligations to be treated.

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