Certificates Of Deposit Aren't Risk-Free

With the stock market gyrating wilder than a dashboard hula doll, you probably want an investment that won’t depress you when you open the paper. Certificates of Deposit or “CDs,” an insured savings account with a guaranteed interest rate may sound like the antidote, but even they are not without risk.

Certificates of Deposit are great savings tools because you can get a guaranteed interest rate for a specific period of time. Unlike savings accounts, which can change their rates at will, CDs are contractual obligations that cannot change without your permission. They are very stable but they aren’t without risk, here are three that you should be aware of if you’re thinking about CDs.

Inflation risk is the greatest risk you face when you deposit funds into a certificate of deposit. Since the interest rate is fixed and because there is a penalty if you withdraw funds before maturity, inflation can invisibly erode your savings. Interest rates on certificates of deposit are already fairly low, because your principal is protected by FDIC insurance, so they are especially susceptible to inflation. If you lock yourself into a multi-year CD and inflation or interest rates rise, you may find yourself holding onto a CD that is costing you money. The real kicker is you’ll have to pay a penalty to close the CD and access your money!

Bank failures aren’t a huge deal when it comes to CDs but it can play a factor if you aren’t careful.

It’s important to understand FDIC insurance coverage limits because many people learned, the hard way, that part of their CD may not be protected if they are near the limit. This is less of a risk now that the limit is $250,000 but before they temporarily raised it, people were discovering that part of their CD wasn’t protected. If you deposit funds into a CD and the interest it accrues exceeds the FDIC coverage limit, then the overage isn’t protected. Fourteen banks have already failed in 2009, joining the twenty-five banks from 2008, this is a tangible risk.

Another risk associated bank failure is that the new bank may not honor the terms of the CD. Banks often jack up interest rates to boost their deposits and the receiving bank is not required to honor those terms (if a bank buys another bank, then they are required to honors those terms; if they receive it through the FDIC, they don’t have to honor the terms). You may think to yourself – “So what? I’m FDIC protected; if they don’t honor it then I go elsewhere.” That is true. However, if you consider the time you lose transferring your funds around, time your funds aren’t earning interest, then it has a real cost to you.

CDs are a safe investment but they aren’t entirely without risk, be sure you understand these three before you open one.

Jim writes about personal finance at his personal finance blog, Bargaineering.

(Photo: spinadelic)