What are the Biggest Risks with Bank CD Investments?

July 20th, 2011 Brock Hailes Leave a comment Go to comments

Bank certificates of deposit or CD’s are one of the safest investment vehicles available but there are at least three key risks involved with bank CD investments which include, withdrawing funds before maturity, interest rate fluctuations and opportunity costs.

The withdrawal of your principal investment or deposit from a bank CD before maturity will usually be subject to a substantial penalty. Withdrawing your CD funds prior to the CD maturity date will invoke an early withdrawal penalty. CD investors that want to get their money back before the CD matures will have to a pay penalty that is usually based on the term of the CD with longer term CDs subject to higher penalties and is calculated based in the interest earned on the CD.

Bank CD rates are subject to interest rate risk. While bank CDs enable the depositors to lock in the interest rate for a guaranteed rate of return, should interest rates rise that fixed return will diminish in value. This is referred to as the interest rate risk of a fixed interest earning asset. If interest rates rise, the market value of outstanding fixed rate CDs will be less valuable than the current higher yielding CDs. As an example, when an investor invests in a five year bank CD with current rate of 4.00%, this return maybe very competitive in the current interest rate environment but should interest rates rise in the near term, the 4.00% yield is not going to look so good. Changes in interest rates increase the longer the investment term, therefore term CD maturities will have greater interest rate risk than short term CDs.

A similar type of risk that follows interest rate risk is purchasing power risk. With purchasing power risk, if the inflation rate increases higher than your CD rate of return, then you will lose some of the purchasing power of your money. Purchasing power risk is a risk that is associated with all fixed income investments from bank CDs to bonds and fixed rate annuities.

A final risk with a bank CD is that of opportunity loss. Investors will often view this as simply accepting lower yields than may otherwise be available in other asset classes. Because of the inherent safety with bank CDs, the yields on CDs are often lower than other higher risk investments. This by no means diminishes the value of bank CD investments, but investors need to be aware that long term CD investments may offer lower returns than the other investment vehicles. Essentially, there may always be better investment options if you are willing to put your money at greater risk.

Before investing in a new bank CD, investors need to evaluate all of their options. Before choosing the bank to open your CD, shop around to compare rates and terms. Bank CD interest rates will vary substantially from bank to bank, making comparison shopping well worth the effort. Investors need to know the different types of CDs available with their comparative advantages and disadvantages. And, of course, bank CD investors need to identify the penalties imposed by the bank for early withdrawal especially on any long term CD investments.

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