As the Fed continues to raise rates, several people have been asking about CD rates. I recently had a conversation with a gentleman who was excited to hear that the fed was raising rates. He was telling me that he was about to move a good chunk of his money into a CD. As he walked away I thought to myself why would anyone want to open a CD when there are other investments that earn more interest?
History
Certificate of Deposit, or CD date back to Europe in the 1600s. The purpose of CD’s were to help the banks lend out money. By locking your money into a CD for a certain time. The banks then could lend out that money to others. In return the bank would pay you in interest for locking your cash into a CD. These rates are typically higher than the average savings account.
Why Banks Like CD’s
Banks make money many different ways, however the most important is through lending. A bank can legally loan 80%-90% of deposited money. This is known as the lending to deposit ratio. That means for every dollar you deposit the bank can lend out 90% of it. This is why you earn interest on savings accounts. The problem banks have with savings accounts is they are liquid, meaning you can take cash out at any time. For a bank this is risky because if you had $1000 in your savings account and wanted to take it out, the bank now has to give you your $1000. However the bank could have just lent out 90% of it. Although there shouldn’t be a problem in paying your money back there must be a better way for banks to lend without having to worry about repaying. That is where CD’s come into play. When you open a CD you lock your money up for a specific amount of time, this can be months or years depending on the term. The bank then pays you a higher interest rate for opening up a CD because you are agreeing not to touch the money for the agreed upon time. To a bank this is wonderful. They now have a way to lend out money without having to worry about you coming knocking on their door trying to withdraw it.
A Thing of the past?
Historically CD’s were a great store of value at times you could have been earing 10% to 12% during the 70s. Then again during 80s. However as time has gone by the rates have gone down drastically. Currently CD rates range from .05% to .35%. To put this in perspective I have gathered data displaying how CD rates have fluctuated since 1964 to current.
Adjusting For Inflation
It would be wrong not to consider inflation when determining whether, a CD is a good investment. If we don’t include inflation in the formula then of course CD’s would be great. A guaranteed return each year for parking your money in a bank, heck yeah! Unfortunately this isn’t the case, that is why we must account for inflation.
The chart above illustrates real data of inflation and CD rates over the past 50+ years. What is unique is that CD rates for the most part have been higher than inflation. If you had CD’s any time from 1964 to late 1990’s then you did great. However since the early 2000s this isn’t the case. Over the past 20 years inflation has been crushing CD rates. What does this mean? It means that CD rates don’t reflect the rate of inflation.
Why Inflation Matters To CD Rates
Inflation by definition is the decline of purchasing power of a currency over time. Inflation is caused by many things, but what’s important is to understand how it affects you. Inflation essentially means that the dollar doesn’t go as far as it used to years ago. Meaning that as time goes by you have less purchasing power than you had before inflation went up. Inflation plays a huge part when considering CD’s.
The visual here shows why inflation is so important when it comes to CD’s. The top portion shows when Inflation was up CD rates also were up and they still returned more than the rate of inflation. The lower portion describes todays markets. What this means is that even though the inflation was high in the 80s, CD rates returned investors a profit of $50.20 after adjusting for inflation. In 2022 CD rates returned investors a loss of $82.50 after adjusting for inflation.
Alternatives
If you are looking to lock your money up for a long period of time and still generate healthy returns there are a few alternatives you have to choose from.
Bonds
Bonds are debt instruments issued by corporations or governments. The investor purchases bonds at a face value and receives interest payment for lending out the money. There are several different types of bonds however there are two bonds that focus on inflation. The first are Treasury inflation protected securities or TIPS. TIPS bonds take inflation into consideration by adjusting the face value of the bond based on inflation. They have a fixed rate but adjust to inflation based on the face value changing due to the increase or decrease in inflation. Another form of inflation adjusted bonds are I-bonds. I-bonds differ from TIPS bonds in that the par value of the bond stays the same for the duration of the bond. The second is that they pay a low fixed rate. The reason they pay a low fixed rate is because they are subject to inflation they pay on the inflation rate. I-bonds pay out semi annually, when inflation is assessed these bonds are paid out at half of the inflation rate. If inflation is 10% I-bonds will pay a semi annual interest rate of 5% every six months. However if inflation is less then it will affect the interest payout of the bond. The reasons that these bonds are a better form of investment is the real rate of return reflects inflation.
Equities
The equities market is a great way for investors to generate good return on investment. For instance the S&P 500 historically averages 10.5% return since its inception in 1957. Unlike CD’s, stocks offer dividends. Dividends are quarterly payouts that companies pay to investors of the stock. The average historical dividend payout of all 500 stocks in the S&P are around 4.3%. Another perk that stocks have in comparison to CD’s is time. Unlike CD’s stocks face value can grow, what does this mean? If you invest in a share of Coca-Cola (KO) at $50 it has the potential to increase in value. Now a year goes by and it could increase to $60 per share. Combine the increase in face value of the stock with the quarterly dividend payouts your rate of return on a share of Coca-Cola is already more valuable than owing a CD. Lastly Stocks offer the opportunity for investors to liquidate easily without penalty. This is extremely important because you don’t know what can happen in the future. You may need cash and liquidating stocks are much easier than closing CD’s. CD’s have early withdraw penalties that stocks do not have making it harder to get access to your money when its locked up in a CD.
Ask A Financial Advisor
When considering CD’s its always best to speak to a financial advisor first. Financial advisors are there to help grow and protect your assets. When speaking to a financial advisor they will help you set up a plan to grow your money and may offer better alternatives to CD’s. A financial advisor can help walk you through many strategies that best suit you and your investment goals.
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