Here's What Happens to Your CD When Interest Rates Drop

The great thing about putting money into a savings account is that you get to earn interest on it without taking on any risk. As long as your bank is FDIC-insured and your deposit doesn't exceed $250,000 (or $500,000 if it's a joint account), you won't risk losing out on any principal the same way you risk losing money by investing in stocks.

But there's a drawback to putting money into a savings account. You might start out with a generous interest rate on your cash. But that interest rate isn't guaranteed to last, and your bank isn't obligated to keep paying it.

You could put $1,000 into a savings account paying 4% interest, and the month after, your account's rate could drop to 3.5%. And then 3% the month after that, and so forth.

The beauty of putting money into a CD (certificate of deposit) is that the interest rate you lock in is the rate you're guaranteed to receive throughout its term. If you sign a 12-month CD at 5% interest, that's the interest rate you'll be entitled to for a full year.

As such, when you sign a CD, you don't have to worry about interest rates dropping, because they won't affect you. But despite this perk, there are some pitfalls of CDs you should know about.

You might miss out on a higher rate

Falling interest rates aren't a concern when you have money tied up in a CD. But on the flipside, when you lock money away in a CD, you also don't get to benefit from rising interest rates.

In other words, let's say you sign a 12-month CD at 5% interest. If, a month later, your bank starts offering that same CD at 5.25%, you're out of luck, because you've already committed to that initial CD.

On the other hand, with a savings account, you run the risk of seeing your interest rate drop from one month to the next. But your interest rate could also rise.

You'll risk a penalty for an early cash out

You may have every intention of keeping your money locked up in a CD for the duration of its term. But what if you end up needing that money in a pinch?

With a savings account, you can take a withdrawal at any time without being penalized. But if you cash out a CD before it comes due, you'll risk a penalty, the amount of which will depend on your bank.

At Capital One, the penalty for cashing out a 12-month CD early is three months' worth of interest. That's a pretty big hit to take.

Be careful when opening a CD

Dropping interest rates don't have to be a concern when you have money in a CD. But do be aware of the aforementioned drawbacks before deciding to open one up. And if you are going to put money into a CD, try to make absolutely sure you can afford to part with it for a period of time.