Key takeaways

  • A CD is one of the safest places to deposit money, but if you need the money before maturity, you could wind up paying a penalty that wipes out some of your principal.
  • Be mindful of inflation chipping away at your purchasing power if your CD’s value is rising at a slower rate than the cost of goods and services.
  • If you want to access cash easily, no-penalty CDs, high-yield savings accounts and money market accounts are better options.
Certificates of deposit (CDs) are attractive options for anyone who wants to save money with a nearly non-existent level of risk. The key word there, however, is “nearly.” CDs aren’t entirely risk-free. Read on to learn more about how CD investing works and what you can do to make sure you don’t lose any of your money in one.

When you can lose money with a CD

Losing money in a CD is very rare, but it can happen. Here’s how:

  • You need your money earlier than expected, and you have to dip into the principal to cover the early withdrawal penalty. For example, let’s say you open a 12-month CD with a deposit of $5,000. One month after you open it, you find yourself in an emergency where you need that money. The early withdrawal penalty is equivalent to 90 days of interest – 60 days longer than you have even been earning interest. In that case, you’ll pay the equivalent of what that interest would have been from your principal.
  • You exceed insurance coverage limits, and your bank or credit union fails. As long as you choose a federally insured bank that’s a member of the Federal Deposit Insurance Corporation (FDIC) insured bank or a National Credit Union Administration (NCUA) insured credit union for your CD, you shouldn’t have to worry about the unlikely event of an institutional failure. Both types of deposit insurance will cover your money in a CD up to $250,000. So, let’s say you deposit $300,000 in a CD, that extra $50,000 can be wiped away if the bank or credit union shuts its doors for good.
  • Inflation is running higher than your CD’s return. Inflation plays an important role in understanding how much your money is actually worth. While you may not feel like you’re losing money in a CD if you’re following the rules and waiting to withdraw at maturity, you can be losing purchasing power. For example, let’s say your CD is paying a 2.5 percent yield but inflation is increasing at a rate of 3.5 percent. In that case, you’re not really doing yourself any favors. “If inflation picks up, the CD holder will be worse off,” says Elliott J. Pepper, CPA, CFP, financial planner and director of tax at Maryland-based Northbrook Financial.

How to avoid losing money with a CD

Keeping your money safe in a CD starts with following these key steps:

  • Verify the bank or credit union has insurance coverage. Before you deposit money in a CD – or any other savings or checking account, for that matter – use the FDIC’s directory to make sure the bank is on the list. And if you’re thinking about joining a credit union, use the NCUA’s directory to double check its credentials.
  • Make sure your emergency fund is healthy and in an easily accessible account. You can avoid considering an early withdrawal by making sure that you have plenty of liquid funds available elsewhere. Think about what’s ahead for your expenses, and be prepared for the worst such as a job loss or a big medical bill.
  • Keep an eye on inflation data and the interest rate landscape. If you open a 3-year CD with an interest rate of 3 percent and rates jump to 5 percent 18 months later, it can make sense to pay the early withdrawal penalty. If there are significantly better rates available, you may not be losing money, but you certainly are losing out on an opportunity. Don’t let it pass you by.

Set up a CD ladder

Building a CD ladder can address the potential risks of CDs. Rather than putting all your money in a 3-year CD, for example, a ladder divides that money across a range of varying maturities. For example, you might open the following CD tiers: 6-month, 9-month, 1-year, 2-year and 3-year. This way, you’ll always have money relatively close to maturity (avoiding the need to pay an early withdrawal penalty), and you’ll be able to constantly shop around for rates when those CDs mature.

What is a no-penalty CD?

A no-penalty CD is exactly what the name implies: There are no early withdrawal penalties to worry about. So, you’ll get the guaranteed rate if you leave the money in for the full term, but if you want or need the money before that term is up, that’s okay, too. No-penalty CD rates are a bit lower than standard CDs, but there are still competitive offers out there that pay significantly more than regular savings accounts.

Alternatives to CDs

Because one of the biggest concerns with a CD is the need to lock your money up for an extended period of time, these two options help avoid that fear while paying a competitive return:

  • High-yield savings accounts: These function just like a regular savings account, but with the added perk of a yield that is likely around 10 times higher than average rates. The only downside to high-yield savings accounts is that rates are variable – unlike CDs. However, if rates move up, you’re in luck.
  • Money market accounts: The best money market accounts pay rates that are in line with high-yield savings accounts. These accounts function like a mix of a savings account and a checking account; some of them even come with a debit card or the ability to write checks. That can be a big drawback, though: Since the money is so easily spent, you can wind up spending rather than saving.

Bottom line

Losing money in a CD is highly unlikely. However, it’s not impossible. If you’re thinking about opening one, read the fine print about early withdrawal penalties, and be sure to compare more flexible options that don’t have a maturity date. And even if you decide to open a CD, don’t set it and forget it. Monitor interest rate movements to make sure your money is growing at the rate you need for your long-term goals.