Are CD’s good investments?

certificates of depositAs a financial planner, I cannot tell you how many times I have had this conversation with clients. I often hear them say, “I do not want to take any risks, so I invest my money in CD’s.” Little do they know, they are taking a bigger risk than they realize by doing this.

For my younger readers who may not be as familiar with certificates of deposit, they are simply an account you open with a bank or other financial institution. In return for locking in your money with them for a set period of time, which can range from as little as a few days to over 10 years, the bank promises you a set rate of return. If you ‘break’ the CD before its maturity date, you are often subject to penalties which can eat up the interest you accrued, and in some cases, even dip into the initial deposit you made. Generally, the longer term you choose to lock the money in for, the higher your rate of return will be.

People consider them to be safe investments for their money. I use the term investment very loosely. They are not an investment at all. They are little more than a savings account in which you forfeited your liquidity for a slightly better interest rate. I cringe when people refer to themselves as investors and then proceed to tell me about all the money they invested in their CD’s.

The reason people feel safer in CD’s is because you do not experience the fluctuations in your principle that you will find with stocks, mutual funds, and even bonds. There is little risk of losing principle in CD’s. The only way you could possibly lose any of your initial investment is if you break the CD very early after purchasing it on a long-term CD, or if the bank were to collapse. Yes, they are FDIC insured, but the FDIC is not obligated to payout dollar for dollar when a bank collapses. They normally do, but they can reach a settlement of as little as $0.50 per dollar. Extremely unlikely, but possible.

So what is the problem with CD’s? They are safe, aren’t they?

Well, I guess it depends how you define ‘safe’. There is a more unperceived risk with CD’s than other investments. As I already discussed, you will not see principle fluctuations, but you are actually losing money with a CD every day.

How am I losing money without losing principle? For some people this is hard to understand, but banks do not pay a rate of return on CD’s that keep up with inflation. The rate of inflation in 2013 was around 1.2%. Now take a look at CD rates. On a 1-year CD today, you can expect about a 1.00% return, and at 2 years it only bumps up to about 1.15%. You can slightly surpass today’s inflation rate if you go to a 3-year term at 1.30%, but then you have to decide if you think that inflation is going to remain this low for 3 years. Historically, it has averaged more around 3-3.5%.

When you put your money into CD’s, you will not lose principle, but you will lose purchasing power. In other words, if you but $5,000 into a CD for 3 years at today’s rate of 1.30%, when that CD matures will you be able to buy the same amount of goods and services with the $5,197.55 you will have at maturity? The answer is no. You do not even have to look at inflation numbers to figure this out. Just think of what you were paying for a shopping cart full of groceries 3 years ago compared to that same cart of groceries today. Is it only 1.30% more? I doubt it.

So I should stay away from CD’s then?

No. I’m not advocating that everybody should stop buying CD’s. I just want more people to understand where they fit into your financial plan. They are not designed to grow your money. They are simply designed to preserve principal. Nothing else. If you have $50,000 sitting in nothing more than a savings account with no plans for it in the next 3-5 years and are already contributing the necessary amount of money to your retirement plan, you might want to consider putting some of the money into a CD to earn a little better return than it will just sitting in a savings account for the next 5 years.

If you have retired, you should start gradually moving your money into less risky options, such as CD’s. You are still going to need some money in the market, but a smaller percentage. You need to look at conserving more of what you have. You cannot stomach fluctuations as much later in life. You do not have as long to recover.

Certificates of deposit do have a place in your financial plan. However, that place is not to make your money grow. They are simply a vehicle for conserving principle.

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