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How risky are certificates of deposit?

Bank deposit accounts such as certificates of deposit (CDs) are often referred to as "risk-free" investments. While CD risk and return is generally at the very low end of the spectrum, it's best not to assume you are immune to risk when you invest in CDs. If you recognize the potential risks, you should be better able to manage them.

There are at least three conditions under which your CDs may incur some form of risk, but you can take steps to avoid problems.

1. Overstepping FDIC insurance limits for CDs

FDIC limits for CDs are the same as for other deposit accounts: $250,000 per depositor, per institution. That's good enough to cover most situations, but despite that protection, there are two situations where people may find themselves exceeding the insurance limit.

CD laddering

Laddering is a strategy of using CDs with different maturity dates to provide liquidity while still enjoying the higher yield available from longer-term CDs. 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.

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.

2. Getting locked into a low rate

Part of the attraction of CDs is that they allow you to sign up for a guaranteed interest rate over the life of your deposit, and the longer the term you choose, the higher the interest rate you get. However, this fixed interest rate can also be a drawback in some situations.

If you sign up for a long-term CD, you risk being locked into a rate if market rates should subsequently rise. If inflation rises after you sign up for a CD, you risk having inflation take a growing bite out of the real value of your CD.

One defense against this is to ladder your CDs. Spreading maturity dates out among different CDs makes money available for reinvestment at regular intervals. Otherwise, you may be tempted to withdraw from your CD early, which could subject you to early withdrawal fees.

3. Early withdrawal risk with CDs

CDs almost always carry a penalty if you withdraw money before the term is up. While the attraction of CDs is that they generally cannot lose value, under some circumstances an early withdrawal penalty could cause this to happen. These penalties are generally more severe the longer the term of the CD, and can range from a few weeks' to many months' worth of interest.

One way to avoid early withdrawal penalties is to think carefully about when you may need the money before you choose your CD term. For less predictable circumstances, such as financial emergencies or rising interest rate environments, laddering is a good technique for making sure at least some of your money becomes available at regular intervals.

Finally, be sure to check on the early withdrawal penalty before you sign up for a CD. Just as CD rates vary greatly from bank to bank, so do these penalties. If you can find a competitive rate with a relatively mild penalty, it goes a long way towards mitigating the risk of early withdrawal.

While CDs represent one of the lowest-risk investments you can make while enabling savers to accumulate more earnings than they would in most savings accounts, they do have some risk associated with them. Managed correctly, most investors can benefit from keeping some money in CDs.

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