7 mistakes to avoid when investing in CDs
Certificates of deposit are generally considered a safe place to stash your money and preserve capital.
Buy from a federally insured institution, and your principal is safe. And savvy investors know where to look for the best CD rates, offers that pay at least twice as much as the average nationally available offer.
You might not know, however, that holding a CD can cost you money and time. But these losses aren't inevitable if you know what to look for. Here are 7 mistakes you’ll want to avoid when investing in CDs to preserve and grow your nest egg.
Mistake 1. You're keeping too much money in CDs.
How much do CDs pay?
|Term||Average APY||Top deal|
|As of Jan. 17, 2014|
Sure, you collect interest on any CD you purchase. But how much are you really making? With interest rates near record lows, inflation eats into any real earnings, especially for shorter-term CDs.
The annual U.S. inflation rate sits at 1.2%, according to December 2013 data from the Bureau of Labor Statistics. Inflation is incredibly low, and yet not one CD term features an average rate above inflation.
Unless you invest in the best nationally available 3- or 5-year CDs, you're actually losing money today.
And two, three or four years from now? The Federal Reserve projects inflation could edge up to 2% or higher.
While once certificates of deposit were a solid investment, today they simply are a place to park some cash safely. For most people, CDs should not make up a large portion of their savings portfolio.
Mistake 2. You've tied up funds you might need to access quickly …
For keeping emergency funds, a savings account is probably a better option than a CD. If you need to withdraw money from your certificate of deposit before maturity, you may incur a penalty.
There are two other problems with putting money in CDs that you might need at a moment’s notice:
- The bank may require seven days' notice to close your CD early.
- Some banks reserve the right to refuse early withdrawals. While it might be bad for the bank’s image if they actually did so, you should be prepared to hold any CD you open until maturity.
If you can’t access your money quickly enough when an emergency arises, you'll incur the costs of borrowing the needed funds or falling behind on your bills.
Mistake 3. … And getting those funds will eat into your principal.
Did we mention those early withdrawal penalties? You'll likely get hit with a penalty if you seek to withdraw money from a CD before maturity. Banks typically describe these penalties as, for example, "180 days’ worth of interest."
In most cases, the early withdrawal penalty doesn't just come out of interest you've actually earned. Most banks will dip into your principal if you haven't earned enough interest to cover the penalty.
Mistake 4. You settled for less than the best rates.
CD rates change frequently, and some banks and credit unions offer above-average promotional rates. If your money is tied up in a lower-interest CD with a stiff early withdrawal penalty, you won't be able to take advantage of these better rates. You're more likely to face this problem the longer your CD's term is.
To earn the highest rates, you’ll need to check rates.
By laddering your CDs so that they mature at different times, and by checking for a more competitive rate before letting a matured CD roll over into a new term, you’ll be able to take advantage of any new, higher rates.
Use our CD calculator to see when moving your money to a new certificate with a higher interest rate means you’ll come out ahead, even after paying a penalty to close a CD early.
Mistake 5. You chose CDs when bonds could lower your tax bill.
The interest you earn on a CD is taxable at both the federal and state levels, so not only is inflation eating into your returns, taxes are, too. For a comparable interest rate, a similar level of safety and some tax savings, you might be better off putting your money in government bonds.
The interest on federal Treasury bonds isn’t taxable at the state level, which means significant savings in states with a high personal income tax rate like California and New York. (This advantage is meaningless in states like Texas that have no income tax.)
The interest paid by municipal bonds, which are issued by local governments and sold through major brokerages, is sometimes tax-free. Just make sure you’re comfortable with the bond’s term and risk rating before you buy.
Mistake 6. You forgot to cash out before your CD rolled over.
Most certificates will roll over automatically at maturity. The institution that holds the CD typically gives you a seven- or 10-day window to withdraw your money without penalty. If you miss that window, you'll pay the full early withdrawal penalty to get your money out.
Don't buy CDs that will be up for renewal at times of year when you're likely to get busy and forget to think about withdrawing money, like near the winter holidays.
Mistake 7. You purchased a CD that pays simple interest instead of compound interest.
Some CDs pay simple interest, which means you earn less. With daily compound interest, you earn interest on your previously earned interest. The balance on which you earn money creeps up every 24 hours, accelerating the pace of your returns.
With simple interest, the bank pays interest just once at the end of the term, only on your original principal amount. For a $1,000 CD paying 2% interest, the difference in simple versus compound interest is $20 vs. $20.20.
It's insignificant at today's interest rates or with small amounts invested, but the difference becomes more meaningful as you invest more and as interest rates climb.