Certificates of deposit may seem boring and predictable. But that’s precisely why some investors find them so compelling, particularly in times of economic uncertainty.
With millions out of work due to the coronavirus and concerns about the trajectory of the pandemic-triggered recession, a top priority for many families is managing money well and protecting their savings.
If you’re looking for a place to park funds for a specific period of time and you value peace of mind, a CD could be worth considering. Here are some of the pros and cons of investing in CDs and what to take into account before taking the plunge.
Pros of CD investing
CDs from federally insured banks and credit unions are backed by the full faith and credit of the U.S. government up to $250,000 per depositor, per insured bank, per ownership category. This essentially amounts to bank-subsidized investment insurance.
“The return of your money is more important than the return on your money,” says certified financial planner Buz Livingston of Livingston Financial Planning in Santa Rosa Beach, Florida. “That’s the benefit.”
According to the Federal Deposit Insurance Corp. (FDIC), the independent government agency that protects the funds deposited in banks, no one has ever lost a single cent invested in FDIC-insured CDs. Funds deposited at credit unions are insured by the National Credit Union Association. Even if a financial institution is forced to close its doors, your money up to the insured limit is safe.
2. Better returns than savings deposits
Because CD account holders can’t take their money back at a moment’s notice like savings account holders can, CDs are more valuable to banks than savings deposits. Banks typically pay CD investors a higher yield in exchange for locking up their money for a set amount of time.
Now that the Federal Reserve is holding interest rates near zero, investing in CDs is less appealing. The best 1-year CDs pay about the same as the best savings accounts. Still, there could be a benefit to locking in a rate with a CD. Savings account yields could drop again.
“One might ask — why would you lock up your money for a year to get the same interest rate (1.5 percent) that you can get in an online savings account?” asks Gordon Achtermann, founder of Your Best Path Financial Planning in Annandale, Virginia. “The only answer that makes sense to me is that you believe the savings account rate will be going down over the next year and therefore your CD will come out ahead.”
3. Fixed, predictable returns
Unlike other types of deposit accounts or investments, savers can count on CDs to deliver a specific yield at a specific time.
Even if interest rates fall precipitously in the broader economy, your rate will remain constant for the full CD term. That guaranteed rate of return makes it easy to do the math and calculate how much interest you could earn through the end of your term, which could be helpful when assessing your financial plan.
4. Wide selection of terms
CDs are available in an assortment of maturities and yields from thousands of different banks and credit unions. You can find CDs with terms ranging from one month to 10 years. This diverse set of options helps investors find a CD that fits their needs.
Given the low interest rate environment we’re in currently, savers who lock in a short-term CD rate right now will be in a good position to take advantage of better rates whenever they start going up again.
“With the yields so low, it is hard to justify tying your money up for a significant period,” Livingston says. “However, for near-term goals, less than two years, a CD could be appropriate and yield more than a money market fund. Plus, some banks offer short-term teaser rates with higher yields.”
5. Wide selection of account options
Investors interested in CDs also have various accounts to choose from. Some banks offer no-penalty (or liquid) CDs, which are ideal for savers who want to snag a decent interest rate but also want the option to close the account — if needed — without incurring an early withdrawal penalty.
Other CDs you might come across include step-up and bump-up CDs, jumbo CDs as well as add-on CDs that allow multiple deposits. If a traditional CD isn’t a good fit, there may be another option that meets your short-term financial needs.
Cons of CD investing
1. Limited liquidity
One major drawback of a CD is that owners can’t easily access their money if an unanticipated need arises. Usually they’ll have to pay a penalty for early withdrawals, which can come in the form of sacrificed interest or even loss of principal.
“During times of uncertainty, liquidity is often paramount. This liquidity could be used for buying opportunities in a distressed market, or could even be essential for covering spending needs so that other long-term investments don’t need to be sold,” says Alex Reffett, principal and co-founder of East Paces Group in Atlanta. “Purchasing a CD can be a reasonable way to earn interest on money that would otherwise be stagnant, however with multi-year CD rates below 2 percent, it may not be worth sacrificing the liquidity for such a small yield.”
One way CD investors can increase their flexibility is to create a CD ladder made up of CDs of differing maturities, so portions of your CD savings will be available at regular intervals.
For example, you could build a CD ladder with three rungs: a six-month CD, 1-year CD and 2-year CD. The shorter-term CD gives you access to some of your cash sooner so you can take advantage of higher rates in the future. The longer-term CD lets you earn the higher yields that are being offered now.
2. Inflation risk
CD rates tend to lag rising inflation on the way up and drop more quickly than inflation on the way down. Because of that, investing in CDs carries the danger that your money will lose its purchasing power over time as your interest gains are overtaken by inflation.
“You are going to be exposed to inflation any time you lock your money up in a fixed-rate investment,” says Michael Foguth, founder of Foguth Financial Group in Brighton, Michigan. “When rates are low, it helps people who want to borrow money, not save money.”
3. Low relative returns
While the yields tied to CDs are generally more favorable than they are for other more liquid bank accounts, returns are typically lower than they are for other higher-risk asset classes such as stocks and ETFs. This presents a problem of opportunity risk.
“If something comes along that offers a real opportunity to grow your money and your money is tied up in a CD, then you lose,” says Lamar Brabham, chief executive officer and founder of the Noel Taylor Agency in North Myrtle Beach, South Carolina. “Although your principal is safe in a CD, you lose. Safety alone is not the only thing to take into consideration.”
A look at historical CD interest rates over the past 30 years shows they have had their ups and downs. In the mid-1980s, 5-year CDs boasted yields exceeded 11 percent, but they’ve trended mostly downward ever since.
Now that CD rates have declined, investors should shop around. As of May 6, the average 60-month CD has a 0.67 percent annual yield, according to Bankrate’s national survey of banks and thrifts. But you can find several 5-year CDs around the 2 percent threshold.
4. Re-investment risk
When interest rates are trending downward, investors who lock in a CD rate will face the predicament of having to invest in lower-yielding CDs when their CD matures. This is known as re-investment risk.
Creating a CD ladder of varying maturities on the shorter end of the spectrum allows investors to take advantage of higher rates as their CDs mature.
5. Tax burden
Another downside for CD investors is the tax you’ll owe on the interest that accrues, which could eat into your earnings, making them virtually non-existent. The same issue comes into play with savings accounts, too.
“Aside from the low interest rates, the taxable interest on low rates could make the net interest even lower,” Foguth says.
As long as you’re aware of the impact taxes could have on your savings, it’s possible to plan ahead and make adjustments, as needed.
It’s best to factor in the pros and cons of CDs if you’re looking for a place to keep your money in the short-term.
The economic environment will no doubt lead you to question whether you should change directions or stay the course. But regardless of what’s happening in the U.S. economy, whether CDs make sense for you should depend on your time horizon (how soon you’ll need the money), as well as your financial plan and goals — not your fears and anxieties.
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