Certificates of deposit (CDs) are a great way to grow your savings for an extended period of time. Many CDs come with fixed interest rates and thus have no market risks, which make them especially attractive for those who don’t want to fiddle around with stocks or other risky investments.
But while CDs are relatively safe, they still have some risks. You might know about early withdrawal penalties — those pesky fees sustained when you withdraw before your CD matures — but if you’re new to CDs, here are five other costly mistakes you should try to avoid.
1. Getting a callable CD
Most CDs can freeze today’s best rates, which is arguably its strongest perk in a shifting rate environment. But not all CD products offer guaranteed returns. Some, like callable CDs, could reduce their APYs at some point during your term.
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Callable CDs are a type of CD that give your bank the option to “call” or redeem the CD before it matures. This would allow your bank to take back your CD and replace it with one that has a lower rate. For instance, you might have a 5-year callable CD with a 4.50% APY. If ongoing rates for 5-year CDs dropped to 3.50%, your bank could choose to call your CD and reissue you another with that lower rate.
Most callable CDs advertise higher rates than traditional CDs upfront. But if your bank calls the CD, you might end up earning less than you would have with a traditional CD. To be sure, callable CDs have a “call protection period,” usually three to six months, during which your CD rate is guaranteed. But once that period is over, it’s fair game for your bank.
2. Getting a CD with simple interest only
Many CDs have the power of compound interest. That is, they earn interest on the money you deposit upfront (principal) and the interest you’ve already accumulated. In contrast, some CDs pay by simple interest, which will apply your interest rate to your principal only, not any interest you’ve earned.
To be sure, nearly all bank CDs have compound interest. But if you’re interested in brokered CDs, pay close attention to how interest is calculated. Most brokered CDs, which are offered through brokerage accounts, pay by simple interest. Sometimes, these CDs have higher interest rates than bank CDs do, which might balance things out. But if a broker and bank CD have the same rate, the bank CD might net more if it earns compound interest.
That said, you can sell brokered CDs on a secondary market. Much like an investment, selling CDs in this way could be profitable, especially if the rate on your brokered CD is much higher than those on the market. But since selling your brokered CD is the only way to exit the contract early (there’s no early withdrawal penalty), this could result in a loss if you’re forced to sell at an unfavorable time.
3. Withdrawing interest
Many banks will let you withdraw interest you’ve earned in a CD penalty-free, even if your principal is still locked up. This could come in handy if you need cash fast for an emergency. But be careful here — any interest you withdraw will reduce your CD’s stated APY.
Again, most bank CDs have compound interest. So if you withdraw funds, you detract some power from the growing pot. For example, if you put $10,000 in a 1-year CD with a 5.50% APY, you’d earn about $273.75 after six months. If you continued earning without withdrawing interest, you’d see $550 by the end of the term. But if you withdrew that $273.75 midway through your CD, you would only earn another $273.75, for a total of $547.50. Not a huge difference, but for larger deposits (and more frequent withdrawals over longer terms), it could end up being more significant.
4. Not realizing your CD rate is annualized
When you see a CD rate advertised, it’s usually something like “5.30% APY.” Don’t miss that APY. It stands for “annual percentage yield,” and it tells you how much your CD will earn within a year, assuming you don’t withdraw interest.
If you see a CD with a term shorter than 12 months, you can’t multiply the APY by your deposit to calculate your earnings. For example, if you want to deposit $10,000 in a 3-month CD with a 5.50% APY, you won’t be left with $550 after three months. Your earnings will be more like $136, assuming you don’t withdraw interest.
5. Overlooking taxes
Finally, don’t forget that CD earnings over $10 will be taxed as ordinary income on the federal and state levels. Your bank won’t withhold taxes for you, so you’ll need to set money aside to avoid any surprise tax bills later. This isn’t the case, however, if you hold your CD in a tax-advantaged account, like an individual retirement account (IRA).
All things considered, CDs can help you grow your savings at a much higher rate than other bank products. Just keep these costly mistakes in mind and stay within the bounds of your CD contract. If you do, you’ll get the full yield from your CD.
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