"What are the Risks of Buying Savings Certificates"

certficate of deposit risk management benefits

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Risks Of Bank Certificates of Deposit:

1. Your financial institution fails, taking your money down with it.

However, since savings certificates are insured by the FDIC up to $100,000, this should not be a big problem unless the entire economy is collapsing.

2. If you invest in a brokered certificate of deposit, and the broker puts your money into a financial institution in which you already have a lot of money on account, you may have more than $100,000 in that financial institution.

The FDIC insures you for up to $100,000, but that includes all money per person per financial institution. Therefore, you never want to have more than $100,000 total in any one bank or savings and loan.

It's not likely (or advisable) to have so much money in any one bank, so the odds of any particular deposit broker putting you over $100,000 are slim. But of course not zero.

Savings Certificate Yields Don't Vary By Much

3. If you entrust your money to a deposit broker, make sure they have a track record and are trustworthy. There are scam artists out there, believe it or not.

Personally, I can't see taking the risk of using a deposit broker just to obtain a slightly higher yield. It doesn't seem worth it, with the exception of known and trusted brokerages. If you have a brokerage account with Charles Schwab or some other established, trusted company, and you want to use them to buy savings certificates instead of your local bank, that makes sense.

4. Call risk.

This is a big one if you have a callable certificate of deposit.

You take out a long term certificate of deposit for $1000 at 8% interest for 20 years. You want to earn that 8% interest for 20 years no matter how interest rates fluctuate in the future.

If they go up to 10% in 5 years, you're stuck -- you cannot withdraw the money without paying the penalty.

But what if it goes down to 5%? The bank decides they don't want to pay you 8% any longer since they can pay new certificate of deposit holders a mere 5%. So they call the CD. Yes, you get the principal of your certificate of deposit back, but now you have to reinvest it for 5%.

With callable certificates of deposits, the bank has no risk. They don't pay a penalty for "early withdrawal" of the savings certificate from YOU.

You locked in your money. If interest rates go higher, you lose and the bank wins (since they're collecting the higher rates on their loans).

If interest rates go lower, you lose and the bank wins (since they call the savings certificates so they no longer have to pay you the higher rate of interest.)

So frankly, I don't see any good reason for putting money into a long term callable certificate of deposit.

A Certificate of Deposit Does Preserve Your Capital - and That Should Not Be Scorned

5. Interest rate risk

I referred to this when writing above about call risk.

If interest rates go up, you're stuck with the rate of interest the certificate of deposit pays. Until the maturity date, unless you accept paying the early withdrawal penalty.

The way to avoid these two risks is to not take out certificates of deposit with a maturity date of more than one year.

Inflation is the Biggest Risk of Putting Your Money Into Savings Certificates

6. Inflation risk

This is the biggest risk of placing your money in savings certificates. They do pay a higher rate of interest than ordinary savings accounts, but they generally do not keep up with inflation.

Therefore, the purchasing power of the interest they pay will go down as time goes by. And so will the purchasing power of the savings certificate principal. The dollar amount is very safe. Place $1000 in a certificate of deposit today for 20 years. In 20 years, you'll almost certainly get your $1,000 back to the penny.

But it will buy a lot less.

And the interest payments sent to you will not have been high enough to keep up with the loss of purchasing power. So that even if you reinvest the interest earned from savings certificates, you cannot keep up with inflation.

Next: What are the disadvantages of certificates of deposit / savings certificates

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