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The Ugly Truth About CDs (Certificates Of Deposit)

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Steve Pomeranz, Certificates Of Deposit

The Ugly Truth About Certificates Of Deposit

Today, let’s talk about the pros and cons of something you’ve all heard about and perhaps even invested in.  I am talking about Certificates of Deposit, also known as CDs.

I’m going to first give you a primer on CDs, talk about where you can find the best rates and discuss the benefits of CDs.  Then, I will tell you why CDs aren’t always the best thing for your long-term investment portfolio and why you may prefer investing in stocks and bonds.  Once you know the pros and cons, I hope you’ll become a better judge of when CDs are right for your portfolio and when you’re better off with other assets.

A Primer On CDs And The Best Rates

Let’s start with a primer on Certificates of Deposit.  CDs are typically offered by banks and credit unions.  Very simply, they are savings certificates that entitle owners to receive interest on their deposits.  By investing in a CD, you lock in a set rate of interest for a specific period of time.

CDs typically come with terms ranging from 3-months to 5-years.  As of early this week, average national rates on CDs ranged from 0.37% for 3-month maturity to 1.72% for 5-year maturity.

But averages don’t always mean a lot.  For instance, the Annual Percentage Yield, or APY, on a 3-month CD currently ranges from 0.25% to 1.77%.

If you’re willing to do just a little bit of research, you can get a much better rate, especially with online CDs.  Online, the highest rate on a 1-year CD is 2.75% and the highest rate on a 5-year CD is about 3.5%—with both rates well above their national averages of 0.92% and 1.72%, respectively.

As an aside, if you want to know the best CD rates, head over to Bankrate.com or check out the link on my website, https://stevepomeranz.com/.

The Pros Of Investing In CDs

Certificates of Deposit are issued by banks, so they come with FDIC insurance of up to $250,000.  Your money is very safe and secure in CDs, with no loss of principal and a guaranteed rate of interest, even if interest rates fall or rise for the broader economy.

This safety of capital makes CDs very attractive for cases where you absolutely do not want to risk losing that money.  Examples include saving for a down-payment on a house or paying your child’s college tuition fees.  This is money you do not want to risk, so a CD gives you that safety while also giving you a modest return.  CDs offer a level of safety and surety that you cannot get with stocks because markets are volatile and your investments could be underwater when you need to withdraw them.

CDs also give you a much better rate of return than simply leaving the money in a savings deposit.  As of November, the national average yield on savings accounts was 0.09%, which is an absolute pittance compared to the 0.92% national average yield on CDs.

For capital that you might soon require and do not want to risk, you’re better off investing in a short-term CD than simply leaving the money in a savings account or exposing it to the volatility of the stock market.

The Drawbacks Of CDs

Now to some of the drawbacks.  Certificates of Deposit almost always have clauses and restrictions such as minimum investment amounts.  Most CDs also charge early withdrawal fees and penalties, which limit their liquidity.

For instance, if you have unforeseen expenses and need to break your CD, you could end up losing all the interest you’ve earned thus far.  You may even lose some of your capital to withdrawal penalties.  Here’s an example: If you close a 2-year CD prematurely, one major U.S. bank will charge you 12 months of interest, essentially decimating your return.

So read withdrawal terms very carefully before you open a CD.

The upside of withdrawal penalties is that you will think twice before you withdraw that money, and you’re more likely to leave it invested for its earmarked purposes.

Low Locked-In Rates Make You Lose Out When Rates Rise

When you put your money into a CD, you’re locked into a fixed annual yield.  But this is not to your advantage when interest rates are set to rise, such as the environment we are in right now, with the Federal Reserve poised to continue raising interest rates.

To understand this point, consider this example:

Assume you buy a 5-year CD today, with a yield of 3.5%.  One year down the road, let’s say 5-year CD rates are at 5%.

You then have two choices: you can either stick with your 3.5% CD for the remaining four-year term, or you can liquidate your CD, pay the withdrawal penalty, and reinvest the proceeds.

Neither of these is an appealing choice.

So it really doesn’t make sense to lock into a long-term CD when rates are rising because your returns will be lower.

Ladder Your CD Investments

Fortunately, there is a solution.  It’s called laddering, and here’s how it works:

Let’s say you like the safety of Certificates of Deposit and want to keep your $10,000 emergency fund in CDs.  But you’re aware that the Federal Reserve is raising interest rates, and you don’t want inflation to eat into your emergency stash.

So, as opposed to putting all $10,000 into a one or two-year CD, you could put $2,500 into a 6-month CD, $2,500 into a 1-y CD, $2,500 into an 18-month CD, and $2,500 into a 2-year CD.  Then, six months from now, you could re-invest proceeds from the six-month CD at a higher rate.  Twelve months from now, you could re-invest proceeds from your 1-year CD at an even higher rate… and so on.

With laddering, you get the safety benefit of CDs, and you do not lose out as much to rising interest rates and inflation.

CDs Significantly Underperform Stocks

Historically, returns from Certificates of Deposit have been significantly less than returns from stocks and bonds over longer periods of time.  Moreover, in a rising inflation and interest rate environment (such as we have now) money invested in CDs could lose its purchasing power if inflation exceeds the yield on your CD.

This is true even today.  The national average 1-y CD rate is 0.92%, which is well below inflation at 2%.  So your money in a 1-year CD will lose its purchasing power over the next 12 months. Now, if you really need to safeguard this money—lock-box it, so to speak—over short periods of time, it’s okay to forego that loss in purchasing power.  But if you’re putting money into CDs purely as a long-term investment, you’re truly better off looking at stocks and bonds.

Consider this:  If you take $100,000 in retirement savings and invest it in a 5-year CD at the average rate of 1.72%, your money will grow to $108,900.  Over the same period, you’d need $110,500 in inflation-adjusted dollars.  So your returns from the CD aren’t even enough to keep pace with inflation.

On the other hand, the same $100,000 invested in stocks may have grown to $137,000 if it consistently experienced a 6.5% annual return every year, assuming reinvestment of dividends.  With stocks, you may have earned $28,000 more over a five-year span in this hypothetical scenario and that might be a strong case to not invest in CDs for you, provided you don’t need the cash for emergencies or other necessary short-term needs.

CD Interest Taxable Each Year, No Long-Term Gains

Finally, with Certificates of Deposit, you can receive payouts either monthly, quarterly, or annually… or reinvest the interest.   Irrespective of the payout option you choose, interest on CDs is part of your ordinary income, so you’ve got to pay taxes on it each year.

If you opt to reinvest the interest, you’re still on the hook for taxes!  Never mind that it’s a five-year CD and you receive no payouts every year.

Now, had you left your money in stocks over five years, you wouldn’t have to pay taxes until you liquidate, or you can deduct your losses.

In summary: laddered CDs are a good way to hold capital that you need to tap into over the next few years, even at the risk of losing some purchasing power to inflation.  But if you’re wanting investment growth for the long-term, you may want to look elsewhere.

Past performance is no guarantee of future results and there can be no assurance that the hypothetical results presented can be achieved. Equity investing involves market risk, including possible loss of principal. CDs are FDIC insured and offer a fixed rate of return, whereas both principal and yield of investment securities have risk and may fluctuate with changes in market conditions. Investments seeking to achieve higher rates of return generally involve a higher degree of risk of principal. Consideration should be given to the possible loss of a part or all of principal invested. Investing involves risk and investors should carefully consider their own investment objectives and never rely on any single chart, graph, or marketing piece to make decisions. The information contained herein is intended for information only, is not a recommendation to buy or sell any securities, and should not be considered investment advice. Please contact your financial advisor with questions about your specific needs and circumstances. There are no investment strategies, including diversification, that guarantee a profit or protect against loss. Past performance doesn’t guarantee future results. Equity investing involves market risk, including possible loss of principal. All data quoted in this piece is for informational purposes only, and author does not warrant the accuracy, completeness, timeliness, or any other characteristic of the data. All data are driven from publicly available information and has not been independently verified by the author..

Steve Pomeranz
I've been an investment strategist and adviser for over 35 years, leading with a mission of unbiased advice to educate and protect listeners on my weekly radio show on NPR affiliates nationwide. I have been named a “Top 100 Wealth Advisor” by Worth Magazine and “Top Advisor” by Reuters.