Can CDs Lose Money? The Risks You Should Know About

Certificates of Deposit (CDs) are a popular savings option, often chosen for their stability and predictable returns. While the principal invested in a CD is generally well-protected, specific situations and market dynamics can impact its overall value or purchasing power. Understanding these nuances is important for any saver considering a CD.

The Core Safety of CDs

A Certificate of Deposit is a time deposit offered by banks and credit unions, where an investor agrees to keep a fixed amount of money for a specific period in exchange for a fixed interest rate. At the end of this term, known as the maturity date, the original principal plus accrued interest is returned to the investor. This fixed interest rate provides a predictable return, making CDs appealing for those seeking stability.

The safety of CDs stems from federal deposit insurance. Deposits in banks are insured by the Federal Deposit Insurance Corporation (FDIC), while those in credit unions are covered by the National Credit Union Administration (NCUA). This insurance protects depositors in the event of a bank or credit union failure, ensuring the return of funds up to a specified limit.

The standard insurance limit for both FDIC and NCUA is $250,000 per depositor, per insured institution, for each account ownership category. This coverage applies to both the principal amount and any accrued interest. For example, a single owner with a CD account at an insured bank would have their deposit fully protected up to $250,000.

Factors Affecting Your CD’s Real Return

While a CD’s principal amount is typically secure, certain factors can diminish its effective return or purchasing power. One such factor is the early withdrawal penalty. If funds are withdrawn from a CD before its maturity date, the financial institution typically imposes a penalty, which is usually a forfeiture of a portion of the interest that would have been earned. This penalty can range from a few months’ interest for shorter-term CDs to a year’s interest or more for longer-term agreements.

If the penalty exceeds the interest earned, a portion of the original principal may be used to cover the remaining penalty, leading to a direct reduction in the initial investment. This scenario can result in a loss of principal. Understanding the specific penalty structure, outlined in the CD agreement, is important before committing funds.

Another significant factor impacting a CD’s real return is inflation. Inflation erodes the purchasing power of money over time. If the interest rate earned on a CD is lower than the rate of inflation, the “real” return on the investment becomes negative, even if the nominal principal amount is preserved. This means the money at maturity, while numerically the same or higher, has less buying power than when it was initially invested.

Rare Scenarios for Principal Loss

Although CDs are generally considered very safe, rare circumstances can lead to a loss of principal. One situation occurs when a depositor holds funds exceeding the federal insurance limits at a single institution. If an individual has more than $250,000 in CDs and other deposit accounts at one insured bank or credit union within the same ownership category, any amount over this limit is not insured. Should that institution fail, the uninsured portion of the deposit could be at risk.

Another scenario involves investing in products marketed similarly to CDs but lacking federal insurance. Some investment products, such as certain structured notes, are not typically FDIC or NCUA insured. While brokered CDs are generally FDIC-insured because they are obligations of the issuing bank, it is important to verify the insurance status of any product. Investors should always confirm that the issuing entity is a federally insured institution and that the specific product is covered by FDIC or NCUA insurance before committing funds.

Key Considerations Before Investing

Before committing to a Certificate of Deposit, it is important for investors to conduct thorough due diligence. Always confirm that the CD is issued by a financial institution that is federally insured by either the FDIC or the NCUA. This step ensures that your principal and accrued interest are protected up to the standard limits in the event of institutional failure.

Reviewing the terms and conditions of the CD agreement is also important, particularly concerning early withdrawal penalties. Understanding these penalties helps in assessing the liquidity of the investment and avoiding potential principal reduction if funds are needed before maturity. Consider your personal liquidity needs and the current inflation environment. Choosing a CD term that aligns with your financial goals and yields a rate competitive with or above inflation can help preserve your purchasing power over time.