Certificates of deposit (CDs) are a go-to savings option for individuals who want a better interest rate than most traditional savings accounts usually offer — but are CDs safe?

The federal government backs CDs through the FDIC or NCUA, meaning these deposit accounts are among the safest financial products available. However, just because CDs are safe doesn’t mean they’re ideal for everyone.

If you’re wondering whether you should open a CD account, read on: We’ll explore the risks and benefits of CDs so you can decide whether to buy a CD or explore other financial  options like annuities or tax-free savings accounts.

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What’s a certificate of deposit?

A CD is a type of savings product that requires the depositor to give up access to their funds for a specific period. In exchange for access to funds, the bank or credit union typically pays the account holder a higher interest rate than they can get with a traditional savings account. 

How do CD accounts work?

Understanding the components of a certificate of deposit will help you choose the right savings vehicle. Here are some key components of a CD account:

• Principal: The amount you deposit in the CD.
• Interest rate: The return you receive in exchange for giving up the use of your funds. 
• Term: The amount of time that must pass for you to access your money without paying a penalty.
• Early withdrawal penalty: The amount in interest that the financial institution withdraws if you break your contract.
• Compound rate: How often the bank adds earned interest to your principal.

Consider this example: You deposit a $10,000 principal in a five-year CD that offers a 5% interest rate compounded annually. If you hold the CD until maturity, you’ll receive $12,762.82. However, if you withdraw funds before the five-year maturity date, the bank or credit union may impose an early withdrawal penalty equivalent to one year’s interest ($500). If you haven’t earned enough interest to cover the penalty, it’ll be deducted from your principal deposit. 

What are the risks of CDs?

As with checking and savings accounts, the federal government insures your money against institutional loss. But how safe are certificates of deposit? If you open a CD, you’ll want to consider the following:

Early withdrawal penalties

One of the most significant drawbacks of a CD is the early withdrawal penalty. Early withdrawal penalties are similar to surrender fees, but banks and credit unions typically express penalties as a period of interest.

Inflation risk

If you lock your money into a long-term CD and inflation rises, your money will lose some of its purchasing power. Additionally, because higher interest rates usually accompany inflationary periods, you’ll lose the opportunity to re-allocate your money into higher-yielding CDs.

Lower returns than other financial products

CDs guarantee your return, and the FDIC or NCUA protects your money against institutional insolvency. But because your risk is low, banks usually offer lower interest rates than other financial products.

Limited liquidity

If you put your money into a CD, you can’t withdraw it until the maturity date without penalty. So if you see a more attractive financial opportunity, that penalty may deter you from withdrawing your money. 

However, there are strategies to circumvent the lack of liquidity. For instance, a CD ladder can give you greater flexibility by spreading your money across several CDs with staggered maturity dates.

Requires research

Your bank or credit union may not offer the best CD rates, or they may charge more fees and penalties than other lenders. It’s in your best interest to research any financial product you’re considering. 

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What are the safeties of a CD?

Are CDs guaranteed? Yes, certificates of deposit have the same federal protections as savings and checking accounts. 

FDIC insurance

The Federal Deposit Insurance Corporation (FDIC) insures CDs up to $250,000 per depositor per institution. Your money is still secure if the bank holding your CD becomes insolvent. 

NCUA insurance

The National Credit Union Association (NCUA) is the credit union equivalent of the FDIC. It offers similar protection on credit union CDs — $250,000 per depositor per credit union.

Pros and cons of certificates of deposit

CDs have several benefits and limitations.

Pros:

• The FDIC and NCUA guarantee most CDs for up to $250,000.
• CDs have a guaranteed interest rate.
• CDs offer numerous options with different terms, compounding periods, and interest rates.
• CDs can provide a better return than traditional savings accounts.

Cons:

• The early withdrawal penalty makes CDs less flexible.
• CDs often have lower returns than other financial products, like annuities or mutual funds.
• CDs carry inflation risk and opportunity loss when rates increase.

9 types of CDs

There are many types of CDs, and lending institutions often tailor the account to your needs. Here are nine of the most common types of CDs available. 

1. Standard CD

If you don’t need immediate access to your funds and want low-risk with a fixed interest rate and term, this type of CD may suit your needs.

2. High-yield CD

These CDs pay a higher interest rate than standard CDs but may require higher deposit amounts and longer terms. 

3. Jumbo CD

Jumbo CDs require a minimum deposit of $100,000 or more. These accounts usually offer a slightly better interest rate than CDs with lower minimums. It’s important to remember that the FDIC and NCUA only insure CD accounts up to $250,000. 

4. No-penalty CD

If you’re concerned about paying an early withdrawal penalty, a no-penalty CD allows you to withdraw your funds at any time. However, no-penalty CD rates are usually lower than CDs with early withdrawal penalties. 

5. IRA CD

An individual retirement account (IRA) CD allows you to deposit pretax money so your money can grow faster. However, you may face IRS penalties for early withdrawal if you’re under the age of 59½.

6. Step-up or bump-up CD

These CDs allow you to increase the return on your principal deposit if interest rates increase. A step-up automatically adjusts your rates at periodic intervals. With a bump-up CD, you can request a single rate adjustment during its lifetime. However, step-up and bump-up CDs usually offer lower interest rates than standard CDs. 

7. Add-on CD

Most CDs only allow you to deposit funds when you open the account. With add-on CDs, you can continue to make deposits over the life of the CD, up to a maximum amount.

8. Brokered CD

Some brokerage firms offer CDs originating through banks, credit unions, or other institutions. Sometimes, you can avoid paying a penalty by selling your CD on the brokerage. 

9. Foreign currency CD

These CDs use foreign currency denominations, which means they’re vulnerable to fluctuations in the exchange rate. Foreign currency CDs aren’t FDIC or NCUA insured. They can offer high returns but are significantly riskier.

This communication / article is for informational / educational purposes only.

It is not intended to provide, and should not be interpreted as, individualized investment, legal or tax advice. The Gainbridge^® digital platform provides informational and educational resources intended only for self-directed purposes.

Shannon Reynolds, is an annuity specialist at Gainbridge^®

Individual licensed agents associated with Gainbridge^® are available to provide customer assistance related to the application process and provide factual information on the annuity contracts, but in keeping with the self-directed nature of the Gainbridge^® Digital Platform, the Gainbridge^® agents will not provide insurance or investment advice.