With so much drama in the stock market, you may be spooked and looking for “safety”. It’s not surprising if you’re wondering whether Certificates of Deposits (CDs) are a good alternative in volatile markets.
Here’s what you need to know.
What’s your investment time horizon?
“CD's can be a great investment option for short term needs. By short term, I mean money you will need access to in less than five years. Investing in the markets should be for long term needs (at least five years). Regardless of market volatility any funds needed in less than five years should not be invested in the market,” says Alan Schoenberger, a certified financial planner with Endeavor Financial Planning.
Cash has once again returned as an asset class in 2019, says Mark Carruthers, a certified financial planner with Cetera Financial Specialists. “Rates are now above zero and some 2-year CD's are yielding 2.5% these days. However, investors shouldn't mix up savings & investing. The first implies emergency and/or rainy-day money with FDIC insurance. The second is long term in nature,” Carruthers points out.
Statistics continue to indicate the best long-term growth is found in equities. Thus, says Carruthers, “although volatility has returned in the fourth quarter of this year and some investors are getting uncomfortable with the stock market, a well-diversified portfolio is still advised for longer term goals.”
Understand the basics
CDs are considered safe investments because there is no risk to principal. “Laddering CD’s of varying maturities is a sound strategy for funding short term goals and emergency reserve requirements (3-6 months living expenses). For longer term objectives a dollar cost averaging strategy is best to take advantage of the market volatility and potentially accumulate wealth,” says Matthew Garrett, a marketing specialist for Glass Jacobson, a provider of accounting and wealth management services.
Do realize though, that when interest rates are rising, locking funds into a CD, especially for a longer period of time – means losing money on the interest. If capital preservation is the primary goal, money market or a 30-day CD should be a much better investment than a long-term CD. In addition, if there is a need for an income stream and total return that is higher than inflation, other fixed Income tools should be considered, for example, an income-producing real estate fund,” explains Garrett.
You can have more than $250,000 in one financial institution with proper structure of “account styling,” points out WenFang Bruchett, author of The C.A.S.H. Formula. FDIC and NCUA insure CD funds if the institution should fail. “CDs are the backbone strategy for any age to cover unexpected emergencies in life,” says Bruchett.
When CDs might not be ideal
“I would not suggest for my clients putting money into a CD even during these volatile markets. Even though the Federal Reserve has recently been raising interest rates, which in turn means that the rate banks are willing to pay on deposits is also increasing, and CDs have started becoming more competitive with Money Markets or other low-volatility investments, there are still negatives to CD savings that I would rather avoid,” says Brent Dickerson, a certified financial planner and owner of Over Coffee Financial.
CDs require that the saver lock-up their savings for a period of time or pay a penalty for withdrawal when they break the cd. “This means that the bank you deposit with has full access to your money, to make loans, for the given time period. This is why they can charge a higher interest rate than if you had saved your money in a simple savings account or interest-bearing checking account,” says Dickerson.
He did a quick search and found that a 9-month CD will return to the saver 1.25%. A five-year CD will return 3.15%. “That is quite a difference, but can you be willing to take such a low rate of return AND not have access to the money if you need it for something? When taken at face value, some might say, I'd rather take 1.25% guaranteed and not have the risk of losing my money. The problem with that is that at 1.25% they are losing their money anyway. With the general rate of inflation at about 2% currently and in the recent past, anything earning interest will fall behind if it is below the inflation number,” he explains.
He offers an example. If you have $1 in a CD earning 1.25% and the inflation rate is 2%, after one year you will have earned $0.25 on your savings but the cost of the goods and services you can buy with that $1 cost $2 one year later.
So, while you increased your money to $1.25, costs have risen so that you lack the appropriate funds to buy the same amount of goods and services you could have bought the year prior. So, a 9-month or even 12-month CD is out of the question unless you want to lose savings in return for stability. There are a few caveats to this: taxes will have an impact as well, some local banks may not be paying as rates as high as those on what is listed his research source, Bankrate.com. “Many local banks are still offering CDs at less than 1%, and many are even below 0.25%.
The bank I specifically found offering 1.25% is Synchrony bank. To my knowledge, they don't make typical loans to customers. They use their deposits to fund high-interest store credit cards. This gives them a higher return on investment and therefore allows for a higher CD rate than a conventional bank. However, they are taking on a lot more risk by issuing credit cards to just about anyone who is breathing, so while it may appear that because it is a CD with no volatility it is safe, there are still risks involved,” says Dickerson.
Remember too, he points out, that any money earned in a regular CD not inside an IRA, will be taxed as income. So, for anyone in the 25% tax bracket, for every $1 earned in a taxable CD, they could be giving $0.25 to Uncle Sam. So, the tax impact has now reduced the 1.25% rate of return to an effective 1.0% rate.