Many consumers like the idea of using CDs for their assets. Cash is seen as fairly safe, and if you make sure your money meets the requirements for FDIC insurance, you don’t have to worry about losing your money if the bank fails.
However, before you decide to put your money in CDs, here are 4 things to keep in mind:
- The Money Isn’t Very Liquid
First of all, you need to understand that money in a CD isn’t very liquid. While it’s cash and cash is generally liquid, a CD is a different story. When you purchase a CD, you agree to leave the money in there for a set period of time. This means that using a CD for an emergency fund, while doable, isn’t always the easiest or best solution. You don’t have easy access to your money, and when you do get access to your money, you are penalized.
- You Pay Taxes on CD Interest in Your Regular Income Bracket
Unlike investment income, which has a favorable tax rate when it is long-term, the interest you earn from a CD is taxed in the year you receive it, and taxed as regular income. You won’t get a tax break on the money, and it will count as income. Even if your bank automatically re-deposits your interest, you will have to pay taxes on it. So, even though you don’t actually get the money in hand, you still pay taxes on it as though it is income. Check the terms of the CD. The only way you get around it each year is if the interest payment is held until the CD matures. Even so, though, you won’t get the favorable tax rate for the income.
- Are You Actually LOSING Money?
When people say that CDs are safe, they refer to the fact that you are most likely keeping your capital safe. It’s not going to disappear. You won’t get negative returns, like you might see in the stock market. However, that doesn’t mean that CDs are risk free. In fact, CDs come with interest rate risks.
Even so called high yield CDs don’t have very high rates. Even the best rate offered on a CD is unlikely to beat inflation — at least in today’s climate. Back when you could earn 5% on a CD, you might have had a chance to beat inflation, but right now that isn’t the case. When you aren’t beating inflation on your earnings, you are losing money in real terms, since your purchasing power is diminished.
- Even Special CDs Aren’t Great Deals
Pay attention the terms when you find CDs that are considered special products. Some CDs offer “bump up” rates or “no penalties”. Realize that these CDs come with their own pitfalls. Often, the initial rates are lower. With bump up CDs, you can usually only bump up the CD once or twice during the term, so you can still miss out. With penalty free CDs, you still have to meet certain requirements, the interest rate might be quite low.
Carefully consider CDs before you put your money in them, to make sure they fit your current strategy.