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Risks of long-term CDs

By Sheyna Steiner · Bankrate.com
Friday, February 11, 2011
Posted: 7 am ET

After steady declines for more than three years, CD rates appear to have hit bottom -- hopefully. The Federal Open Market Committee began slashing the Fed funds target rate in September of 2007. CD rates began to fall thereafter and here we are, about 40 months later, with the average yield on a one-year CD at 0.48 percent for the past eight weeks.

Longer-term maturities offer savers better yields, but many investors are understandably cautious about locking in to a long-term commitment with a rate increase from the Fed sure to come -- at some point.

There are a couple of reasons for that reticence.

  • CDs are an illiquid investment; to get money out of a CD, investors must generally pay an early withdrawal penalty.
  • The interest rate risk: no one wants to be long and wrong when interest rates begin going up.

The severity of the early withdrawal penalty varies from bank to bank. As Bankrate's 2010 early withdrawal penalty study found, the average early withdrawal penalty for maturities of one year or more is equal to 180 days of interest. For CDs with maturities of less than one year, the penalty is 90 days of interest.

Some banks charge prohibitively high early withdrawal penalties and some exotic CDs may disallow early withdrawals altogether.

As a result, investors can find themselves stuck with a relatively low-yielding CD in a rising interest rate environment.

As no one can predict when rates will go up, using a CD investing strategy such as a ladder or barbells can mitigate interest rate risk while keeping enough liquidity in your CD portfolio to reinvest in better opportunities as they arise.

A previous blog post, "Barbells bump up CD rates," illustrated how savers can take advantage of higher yields on longer maturities and get around the problem of the early withdrawal penalty.

How do you feel about CDs today?

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