CDs Are More Risky Than You Think. Here's Why

Money you have socked away to cover emergency expenses should sit in a savings account. That way, you have easy access to it at all times.

But if you have money you don't need for emergencies, you might consider putting it into a certificate of deposit, or CD. The upside of going this route is that you'll commonly snag a higher interest rate on your money compared to a regular savings account. And the interest rate you sign up with is guaranteed throughout the term of your CD (whereas the rate on your savings account could fall at any time).

Plus, as long as you limit yourself to a $250,000 deposit and your bank is FDIC insured, your principal CD deposit is safe. So if you put $10,000 into a CD and your bank fails, you're guaranteed not to lose a dime of that $10,000.

But while CDs might seem like a risk-free endeavor based on all of this, the reality is that they can be more risky than you'd think. Here's why.

You could end up getting hit with a penalty

When you open a CD, you're committing to keeping your money there for a preset period. So if you cash out your CD early, you should expect your bank to impose a penalty.

Now, the extent of that penalty will hinge on where you bank and the duration of your CD. At Capital One, for example, CDs with a term of 12 months or less impose a penalty equal to three months of interest for cashing out early. Your bank might have a different policy, and it's always a good idea to ask about penalties before opening a CD.

You can minimize the risk of facing a penalty by laddering your CDs rather than putting all of your extra cash into a single one. In the case of a $10,000 deposit, dividing it into four and opening 12-month CDs in the amount of $2,500 each at three-month intervals will have portions of your money freeing up regularly. But even then, you risk an early cash-out penalty if your financial circumstances change and you need that money immediately.

You could lose out on growth

The nice thing about CDs is that you don't risk losing out on principal the same way you do by investing your money. But instead, you face another risk -- not meeting your financial goals in the long run due to limiting your money's growth.

Over the past 50 years, the stock market's average return, as measured by the S&P 500 index, is 10%. If you put $10,000 into CDs over the next 20 years that pay you 5% interest (which is feasible today but a high rate historically), you'll end up with about $26,500. Invest that money in stocks over 20 years at a 10% return instead, and you'll be looking at a little more than $67,000. That's a huge difference.

CDs are generally considered to be a risk-free option for parking your cash. But be mindful of these pitfalls before you commit to one.