The Risks of CD Savings Accounts

CDs are reliable savings devices, but they do carry risks.

Certificates of deposit, commonly referred to as CDs, are FDIC-insured, interest-bearing accounts offered by banks and other financial institutions. When an investor puts money into a CD, he essentially buys a set amount of a bank's debt. He agrees not to withdraw his money for a given period of time, and the bank guarantees a certain amount of interest on the account once it reaches maturity. Financial advisors consider CDs to be one the most secure investments, but such accounts have certain risks that potential depositors should consider.

Does FDIC Insured Mean Risk Free?

The Federal Deposit Insurance Corporation insures up to $250,000 of an individual's single account deposits per bank, as of 2011. CDs are FDIC insured, but some people choose to invest substantial amounts of money in CDs without understanding that the FDIC insurance limit is a per bank limit, not a per account limit. If someone has $150,000 in a CD and $200,000 in other single accounts with the same bank then she stands to lose $100,000 if the bank fails.

Early Withdrawal Penalties

CDs typically pay higher interest rates than other forms of savings accounts because they are not liquid assets, but such an arrangement has its downside. When an investor purchases a certificate of deposit, he enters into a contract with the bank for a set period of time -- usually not less than six months and not more than 10 years. Banks discourage withdrawals from a CD before its maturity date by imposing substantial penalties, often as much as 20 percent of the deposit's total value. Unlike IRAs or other restricted accounts, CDs almost never offer any exceptions for early withdrawal penalties.

Interest Rate Fluctuations

Banks primarily offer two types of interest-bearing CDs: fixed- and variable-rate certificates. A fixed-rate CD guarantees a given interest rate that never fluctuates. However, a variable-rate CD starts at a given rate and then adjusts itself at predetermined intervals. Typically, banks peg variable rate CDs to U.S. Treasury notes. As the interest rate on the linked treasury note rises and falls, the CD's interest rate adjusts accordingly. If economic conditions sour after the purchase of a variable rate CD then the CD's lifetime yield could decrease dramatically.

Callable CDs

Some multi-year CDs, especially high yield, come with a call period ranging from three to 12 months. A callable CD is one that the banks can "call away" from the CD owner within the call period. In essence, a call period allows the bank to cancel its contract and return a depositor's money. Investors often put money into variable rate CDs when they anticipate an improving economy and into fixed-rate CDs when they expect an economic downturn, but callable CDs diminish the security of such an investment strategy and may result in a depositor earning far less interest than she anticipated.

References

• U.S. Securities and Exchange Commission; High-Yield CDs -- Protect Your Money by Checking the Fine Print; December 2008
• Federal Deposit Insurance Corporation; When a Bank Fails - Facts for Depositors, Creditors, and Borrowers; July 2010
• Federal Deposit Insurance Corporation; Certificates of Deposit: Tips for Savers; July 2010
• Alabama Securities Commission; Some CD's Aren't What They Seem; August 2001