Can you lose money in a CD?

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Certificates of Deposit (CDs) are often considered one of the safest places to store your money. In exchange for locking up your funds, CDs offer higher rates than regular savings accounts, helping you grow your savings faster. 

While CDs are generally safe, it is possible to lose money by opening a CD if you're not careful. Before investing in any financial product, it's crucial to understand how it works and the potential risks.

How CDs work

When you open a CD, you agree to leave your money in the account for a period known as the CD's term. Terms can range from a few months to several years, with longer terms generally offering higher interest rates. Banks often offer higher interest rates on CDs than traditional savings accounts in return for this commitment. 

CD safety 

A key aspect of CD safety is the guaranteed return. When you open a CD, you agree to leave your money in the account for a specific term. In return, the bank guarantees a fixed interest rate for that period. 

This guaranteed return sets CDs apart from many other investment options. Unlike stocks or bonds, whose values can fluctuate based on market conditions, the value of your CD is predetermined and locked in when you buy it. You know exactly how much your investment will be worth at maturity, providing a level of certainty that's rare in the investment world.

CDs are also considered safe investments because they're covered by the Federal Deposit Insurance Corporation (FDIC). FDIC insurance covers up to $250,000 per depositor per account type. If your bank is unable to return your money due to financial difficulties, the FDIC will reimburse you for the amount lost, up to the $250,000 limit.

Most people don't keep more than $250,000 in a single bank account, which makes CDs a nearly risk-free investment. However, there are still some scenarios where you could potentially lose money with a CD.

Scenarios where you may “lose” money in a CD

Early withdrawal penalties 

When you open a CD, you promise to keep your money in the account for the entire term. Banks rely on this commitment to use their money for other purposes, such as lending to customers. You'll face an early withdrawal penalty if you need to withdraw your money before the CD matures.

These penalties vary by bank and often depend on the length of your CD term. They're usually expressed as a certain number of months' worth of interest. Sometimes, the penalty might even eat into your principal if you withdraw very early. This is more common with long-term CDs. 

Here’s a look at some of the early withdrawal penalties from major banks 

To avoid early withdrawal penalties, only deposit money you're certain you won't need during the CD's term. Consider shorter-term CDs if you're unsure about your future financial needs.

“The bonus of a CD is that you lock in your interest rate for a certain period. The problem with CDs is that the same lock means you have limited access to your money unless you pay a penalty,” says Jay Zigmont, certified financial planner and founder of Childfree Wealth®. “The result is that you need to be pretty sure about your money needs before buying a CD.”

Inflation risk 

While CDs offer guaranteed nominal returns, they're still subject to inflation risk. This means your purchasing power may decrease over time if the inflation rate exceeds your CD's interest rate.

To understand inflation risk, it's important to differentiate between nominal and real returns. The nominal return is the stated interest rate on your CD. For example, if your CD has a 2% APY, that's your nominal return. 

The real return is your return after accounting for inflation. It's calculated by subtracting the inflation rate from your nominal return.

If you open a 1-year CD with a 2% interest rate, but inflation is 3% during that year, your money will have less purchasing power when the CD matures, even though you've earned interest. In this scenario, your real return would be -1%.

“CDs provide an attractive interest rate but may not keep up with inflation,” Zigmont says. “To beat inflation, your long-term money may be better off invested in the stock market.”

To minimize the impact of inflation, consider laddering your CDs or investing some of your money in higher-risk, higher-potential-return options like stocks or bonds.

Opportunity cost

Opportunity cost refers to the potential gains you miss out on by choosing one investment over another.

"Like most financial decisions, looking at the idea of losing money through a CD in terms of opportunity cost is best," says R.J. Weiss, a certified financial planner. "While CDs offer a guaranteed return and are unlikely to lose principal, they may cost you in other ways."

When you put money in a CD, you can't use it for other purposes. For example, if you invest in a 5-year CD with a 2% APY, and during that time, the stock market experiences average returns of 10%, you've missed out on those higher potential returns. While you haven't lost money in absolute terms, you've lost the opportunity to earn more.

This opportunity cost can be significant, especially over longer periods. It's one of the main reasons why financial advisors often recommend a diversified investment strategy that includes a mix of different asset types based on your risk tolerance and financial goals.

Taxes on CD interest

The interest you earn on a CD is generally taxable as ordinary income in the year it's paid or credited to your account, even if you don't withdraw the money.

This tax burden can reduce the effective return on your investment. In some cases, particularly if you're in a high tax bracket and the CD interest pushes you into an even higher bracket, you might find that your real return is minimal or negative after taxes and inflation.

There are ways to mitigate this tax impact, such as holding CDs in tax-advantaged accounts like IRAs. But for CDs held in taxable accounts, it's crucial to factor in the tax implications when calculating your expected returns.

When CDs can be a smart choice

Despite the potential risks, CDs can be a smart choice in certain situations. They offer a guaranteed return and a safe place to store your money for a set period. 

If you have a specific goal, such as saving for a down payment on a house or a new car, a CD can help you grow your money. CDs shine as a low-risk place to store your cash while earning a better interest rate than you’d get from most savings accounts. 

CDs can also be a good choice for risk-averse investors who want to add a low-risk component to their investment portfolio. Thanks to FDIC insurance, you can be confident that your money is safe, even if the returns may be lower than other investment options.

When to avoid CDs 

While CDs have merits, they're not always the best choice. If you need quick access to your funds, a high-yield savings or money market account may be better.

The same goes for savers with a long time horizon. If you're saving for long-term goals like retirement, you may be better served by investments with higher growth potential, such as stocks or mutual funds.

Lastly, CDs may not be the best investment when interest rates are low or inflation is high. When interest rates are very low, the returns on CDs may not keep pace with inflation, eroding your purchasing power over time. If inflation rates are higher than CD rates, you're effectively losing money in real terms.

How to avoid losing money in a CD

While CDs are generally low-risk investments, there are strategies you can use to minimize risk and maximize returns.

CD laddering

CD laddering is a strategy that involves dividing your investment across multiple CDs with staggered maturity dates. This approach balances earning higher interest rates on longer-term CDs and maintaining some liquidity.

Here's how a basic 5-year CD ladder might work:

1. Instead of investing $10,000 in a single 5-year CD, divide it into five $2,000 portions.
2. Invest in five CDs with terms of 1, 2, 3, 4, and 5 years.
3. As each CD matures, reinvest it in a new 5-year CD.
4. After five years, you'll have a 5-year CD maturing every year.

This approach offers several benefits. It offers regular access to a portion of your funds and the ability to take advantage of rising interest rates. Plus, it reduces the impact of interest rate fluctuations on your overall investment. 

Shopping for the best rates 

CD rates can vary between banks, and even small differences in APY can add up over time, especially for larger investments or longer terms.

Online banks often offer higher rates due to lower overhead costs. Some banks may occasionally offer special high-yield CDs to attract new customers.

Remember, while a higher rate is attractive, it's important to ensure the institution has FDIC insurance. You should also consider the bank's reputation and customer service quality.

Comparing CDs to other options 

When considering where to invest your money, it's smart to compare CDs to other common investment types. 

* Averages based on internal Bankrate data.

Savings accounts offer the highest liquidity among these options, allowing you to withdraw your money without penalty. While some traditional savings accounts offer low rates, you can find high-yield savings accounts with rates as high as 5.00%. Like CDs, they are FDIC or NCUA insured, making them very safe, but the trade-off is minimal growth potential.

Alternatives to CDs 

If you’re not sure that a CD is right for you, there are other options that may fit the bill.

• High-yield savings accounts: These accounts offer higher rates than traditional savings accounts while still providing easy access to your money. However, their interest rates may be lower than those of CDs.
• Money market accounts: Money market accounts also offer competitive interest rates and more flexibility than CDs. They often come with debit cards and check-writing privileges but may require higher minimum balances.
• Short-term bond funds: These funds invest in bonds with short maturities and can offer higher returns than CDs. However, they are not FDIC-insured and carry more risk. Value can fluctuate based on interest rate changes and the creditworthiness of the bond issuers.
• Brokered CDs: These CDs are offered by brokerage firms and can be traded on the secondary market. They may offer higher rates than traditional CDs but come with additional risks, such as the potential for loss if you need to sell before maturity.

The bottom line 

CDs are among the safest investment vehicles available. The FDIC insures their principal and returns, providing a level of security that's hard to match with other investment options.

However, "safety" in investing isn't just about preserving your principal. It's also about maintaining and growing your purchasing power over time. While CDs excel at protecting your initial investment, they may fall short in scenarios of high inflation or when compared to the potential returns of riskier investments over long periods.

Deciding whether to invest in a CD depends on your financial situation, goals, and risk tolerance. While you're unlikely to "lose money" in the traditional sense with a CD, it's crucial to consider the broader context of your investment strategy and economic conditions.

Editorial disclosure: Opinions expressed are author's alone, not those of any bank, credit card issuer, or other entity. This content has not been reviewed, approved, or otherwise endorsed by any of the entities included in the post.