In times of economic and stock market turmoil, many investors look for ways to increase the safety of their investments. Looking for investments that are likely to provide safety, rather than high returns, become the priority when people are worried about what’s coming in the economy.
Cash becomes preferred during times like this. As a result, CDs are popular. One of the reasons that people like to put money in CDs is because they are considered “safe”. With a CD, you aren’t going to see capital losses. You don’t lose out the way you might with stocks, and you don’t have the risk of default like you have with bonds. The money you put into a CD is protected from bank failure if your institution is FDIC-insured.
However, because CDs are so safe, they come with a different risk. You could lose money with your CDs simply through the effect of inflation on your purchasing power.
CDs and Low Interest Rates
Right now, we are in a low-rate environment. Many savers are hoping that the Federal Reserve will taper its asset purchase program and prompt higher interest rates, but that’s not something that is likely to happen as fast as many would like. In fact, after the most recent FOMC meeting, the Fed announced that it is putting off the start of the taper. This disappointed many people, since there were analysts counting on the Fed to start tapering.
Once the Federal Reserve starts increasing interest rates, things are likely to move at a fairly slow pace. The Fed won’t want to risk stifling economic growth with dramatic rate hikes, so almost everything is going to be done at a measured pace. That means that interest rates will likely remain low for several years.
But, even if things change, and CD rates start to rise, CDs are still fairly low-rate investments. Sure, you lock in a guaranteed return, and there are some CD products that have the potential for higher returns. In the end, though, CDs just don’t offer a very high return. You are lucky to find CDs that offer 5% to 7% APY even in the best of times. Most of the time, you are going to see the best rates offered at right around 3% or 4%. In a low rate environment, like now, 1% is much more common.
Even the best CD rates are hard-pressed to offer returns that can significantly beat inflation. And that’s where you might see losses over time.
Inflation and Real Losses
CD rates allow you to lock in a certain return. For many, this surety is desirable. You never know, from one day to the next, how stock prices are going to perform. With a CD, though, you know that you are going to get the same yield every year, until the CD matures. And, because this is a cash product, you don’t ever have to worry about losses, as long as you purchase your CD through an institution that is insured by the government. Look for FDIC insurance for banks and FOMC coverage for credit unions.
However, even as the CD offers regular returns, the economy changes. Inflation is a measure of the rise in prices. It is also expressed as a loss in purchasing power, or the loss in the value of a dollar. Think about it: How much did a candy bar cost when you were a child? How much does it cost now? That change in price is inflation. Your dollar might have purchased two candy bars when you were growing up, but now you can’t even get one candy bar with that same dollar.
Overall, inflation might account for a rise in prices of 2% to 3% a year (most economic and investment models assume inflation at 3% per year). If your CD only yields 1.20% for the year, you can see how that would result in an overall loss. Indeed, if you rely too heavily on cash products like CDs, the chances of you building enough wealth over time to offset the influence of inflation are fairly slim.
In a better rate environment, you might be able to use CDs for capital preservation. You might be able to find a long-term CD (five years or more) with a yield of 4.5%. This was a possibility prior to the financial crisis of 2008. If inflation runs 3% a year, you end coming out ahead, with a real return (without taking into account taxes) of 1.5%.
While it’s still not enough to help you build wealth for a comfortable retirement, it does, at least, protect your purchasing power. But you do have to watch out for taxes. Your CD interest will be taxed at your marginal tax rate as ordinary income, so that will increase your loss. In fact, once taxes are considered, even a “good” CD might not provide you with enough of a yield to do more than keep pace with inflation. Your capital might be preserved, but your real returns will be zero — and might even end up being negative. This prevents you from building real wealth to provide you with financial security.
For best results, you need to develop a comprehensive plan for your money. Look for ways to balance capital preservation and safety with growth for the future. You can diversify your portfolio to include stocks and bonds in addition to cash so that you get some balanced growth with your capital preservation. And realize that in a low-rate environment, you can still lose, even when you keep your money in cash.