When most people think about investing, they think about stocks, bonds, and other traditional options. However, another option is often overlooked: certificates of deposit (CDs). CDs are a great way to save for the future, but is it possible for them to lose money? In this guide, we will explore how CD investments work and whether or not they can generate negative returns.
Can A CD Lose Money?
When you invest in a CD, you essentially lend money to a financial institution for a set period. Then, the bank agrees to pay you interest at a predetermined rate in exchange for your deposit.
CDs typically have terms ranging from six months to five years; the longer the term, the higher the interest rate.
Once the CD matures, you will get your original investment back, plus any interest accrued.
So, how is it possible for a CD to lose money?
Well, it all has to do with interest rates.
If the interest rate on your CD is lower than the inflation rate, then your money will be worth less at the end of the term than it was when you started.
For example, let’s say you invest $1000 in a CD with a five-year term and an interest rate of two percent. At the end of those five years, you will have your original $1000 plus $105 in interest, for a total of $1105.
However, if inflation were three percent over that same period, your $1105 would only be worth the equivalent of $1000 in today’s dollars.
In this case, you would have lost money on your investment even though you didn’t lose any of your original principal.
Locked Into A Lower Interest Rate
Another way that a CD can lose money is if interest rates rise after you make your deposit.
For example, let’s say you invest $1000 in a CD with a one-year term and an interest rate of three percent.
A few months later, the Federal Reserve raised interest rates, and the going rate for one-year CDs jumped to four percent.
If you had waited to invest your money, you could have earned a higher return on your investment.
However, because you locked in your interest rate when you made your deposit, you will only earn three percent on your CD regardless of current rates.
This can cause you to lose money if rates continue to rise over the term of your CD.
Another way that CDs can lose money is through taxes.
When you invest in a CD, your interest is considered taxable income each year.
So, if you are in a higher tax bracket, you may pay more taxes than you would with other types of investments.
For example, let’s say you invest $1000 in a CD with a five-year term and an interest rate of four percent.
At the end of those five years, you will have earned $200 in interest.
If you are in the 25 percent tax bracket, you will owe $50 in taxes on that interest, leaving you with a total return of just $150.
However, if you had invested in a tax-advantaged account like a fixed annuity, you would have been able to keep all of that interest.
The Bank Or Credit Union Goes Out Of Business
Finally, it is important to remember that CDs are not without risk.
If the bank or credit union where you have your CD goes out of business, your money could be at risk.
The FDIC (Federal Deposit Insurance Corporation) insures deposits up to $250,000 per account, so you would not lose any of your principal up to the insured amount.
However, you would not be able to access your money until the FDIC resolved the issue, which could take several weeks or even longer.
The dollar amount above the $250,000 limit would not be insured so you could lose some or all of that money.
In conclusion, while CDs are considered to be a safe investment, there are several ways that they can lose money.
How To Minimize The Risk Of Losing Money In A CD
While a CD can lose money, there are ways to minimize the risk. One way is to choose a longer-term CD. The longer the term, the less likely inflation will outpace the interest rate.
Another option is to invest in a CD ladder. This strategy involves investing in multiple CDs with different maturity dates. That way, even if one of your CDs loses money due to inflation, you will still have others that mature later and maybe earn a higher interest rate by then.
The bottom line is that, yes, a CD can lose money. However, this only happens in specific circumstances and is not a big risk. For example, if you are worried about losing money on your investment, you can always choose a shorter term to cash out if rates start to rise. Or, you can invest in a CD ladder to help mitigate the risk of losing money on your investment.
Frequently Asked Questions
Can you lose principal in a CD?
The answer is no, as long as you don’t need the money before the CD matures. Your principal is always safe in a CD. However, there are other ways that CDs can lose money.