3 Little-Known Drawbacks of CDs

Certificates of deposit (CDs) are a hot topic lately. Interest rates for banking products like these are currently very high, with some offering over 5%. But we don't know how long this will last. There's a good chance that rates come down this year.

If you get a CD, you typically don't need to worry about rates dropping since you lock in a fixed interest rate for the entire CD term. You can pick a term that works for you. Top CDs generally range from one to five years, but there are also shorter and longer options available.

While CDs are a safe place to put your money, they have a couple of drawbacks that don't get discussed often.

1. The rate isn't always guaranteed

The big perk with CDs is that you get to lock in an interest rate. But with one type of CD, the rate isn't as locked in as you might think.

Callable CDs often have higher annual percentage yields (APYs) than traditional CDs do. The disadvantage is that the bank can "call" the CD, meaning it takes back your CD and issues you a new one with a lower rate.

With these CDs, your rate is only guaranteed for a short time, referred to as the call protection period. Call protection periods vary, but they could be just three to six months.

Since interest rates could drop, opening a callable CD is risky. If rates go down by a large amount after you open your CD, the bank could call it, and you'll lose that high APY.

2. CD returns are lower than what you can get from other investments

Some people open CDs because they want a safe investment. And CDs are safe, but that safety comes at a cost.

If you want to invest, CDs don't offer the best returns, even at their current rates. You can get an APY of about 5% to 5.5% from a CD right now. The stock market has an average annual return of about 10%. Here's the kind of difference this makes:

• If you invest $10,000 in CDs for 10 years at a 5% APY, you'll have $16,289.
• If you invest $10,000 in stocks for 10 years and get a 10% annual return, you'll have $25,937.

The downside of investing in stocks is that returns aren't guaranteed. They can also be volatile from year to year. Your investment could go up by 20% one year, and drop by 10% the next.

So CDs are a better option for short-term investments if you think you'll need the money within the next five years. For anything longer than that, consider going with stocks over CDs.

3. You'll pay taxes on the interest

The interest you earn from a CD isn't tax-free. It's taxed as ordinary income. You'll need to pay federal income taxes on it, and also state income taxes if you have those where you live.

One CD alternative that could help you save some money on taxes is Treasury bills (T-bills). These are bills with a fixed interest rate issued by the U.S. Treasury. As far as rates go, CDs and T-bills are comparable, although it depends on how long of a term you want.

The advantage of T-bills is that they're exempt from state income taxes. If your state has a high income tax rate, then you may want to go with a T-bill instead of a CD.

CDs aren't a bad investment choice by any means. But it's important to be aware of their drawbacks before you open one for your savings.