3 of the Worst Mistakes You Can Make With a Certificate of Deposit
CDs are safe and relatively risk free -- that is, if you don't make these three common errors. Find out what they are and how to avoid them.
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With guaranteed rates of return (and generous APYs), certificates of deposit (CD) are a nifty tool that can grow your money at a fixed rate. But they're not totally risk free. While your money is protected under FDIC insurance (as long as the issuing bank has it), you can make some mistakes that can limit your earnings or damage your deposit. If you're looking to buy one of today's best CDs, here are some mistakes to avoid.
1. Withdrawing interest
Often banks will give you the option of withdrawing interest as it accrues within your CD. You'll more commonly see this on long-term CDs (those with terms longer than 12 months) but some short-term CDs will let you cash out some interest, too.
If you need cash fast, there's nothing wrong with withdrawing some interest before your CD matures. But keep in mind that withdrawing interest can reduce a CD's stated APY. As long as your CD has compound interest (and most CDs do), any interest withdrawal will leave less money in the pot to grow. Your principal will still sprout interest, but you might have less overall earnings at the end of your CD's term.
Again, if you need this money for an emergency, it would be better to tap into your interest than break your CD contract. Otherwise, let your savings grow undisturbed to capture the highest return.
2. Locking into an abysmally low APY
These days, the most competitive short-term CDs are paying out at rates near about 5%, while long-term CDs (terms higher than 12 months) have rates above 4.50%. If you come across a CD with a rate lower than that, it's likely not a good deal.
This is important to keep in mind because many banks are advertising their rates as competitive. But much like a coffee shop that claims to serve the world's "best cup of coffee," "competitive" can mean anything, which is another way of saying it can mean nothing at all. Only by shopping around and comparing rates can you verify whose offers are truly competitive -- and whose rates are ridiculously low.
3. Paying the early withdrawal penalty
I saved the best (or worst) for last: the early withdrawal penalty (cue the spooky piano music and haunted house screams).
An early withdrawal penalty is the price you pay to liquidate your CD before maturity. It's equal to a fixed period of interest, like six months' worth. For instance, for a penalty worth six months' of interest, you would pay that much even if you liquidated your CD after three months. Translation: You can lose money in a CD.
Early withdrawal penalties can be really harsh. Most short-term CDs have penalties worth three to six months of interest, while long-term CDs can have penalties worth 18 months or more. Not only do you pay the penalty outright, but you also have to factor in your opportunity cost, that is, what you could have earned if you had deposited the money in a more flexible account like a high-yield savings account.
While you can't get around the early withdrawal penalty when you already have a CD, you can proactively prevent putting yourself in that situation with a no-penalty CD. No-penalty CDs are pretty much how they sound: A CD that doesn't impose a penalty. You can find some great high-yield no-penalty CDs on the Raisin platform, but don't expect long terms (for the most lucrative APYs, this means 12 months or fewer).
If you can avoid these three mistakes, CDs can be a virtually risk-free investment that locks you into a guaranteed rate of return. As long as you play by the rules, they'll help you outpace inflation without the risks of other investments. Take a look at some of the best CD rates and see how much they could earn for your savings.
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