Certificates of deposit: Pros and cons weighed
Posted
Nov 04 2008, 08:08 AM
by
Karen Datko
Rating:
This post comes from partner blog Blueprint for Financial Prosperity:
For the last 10 years, certificates of deposit have gotten a terrible rap. Interest rates were low compared with the blockbuster returns of the stock market, and you were locked into that CD for 12, 24 or even 60 months, all making it an unappealing investment option.
For many, CDs came up in financial conversation only when you were talking about laddering an emergency fund because protecting principal was your No. 1 goal.
Times have changed. CDs have once again come into vogue as investors have plowed hundreds of billions of dollars into the CD market. Here are three good reasons you should save with CDs and three reasons why you shouldn't.
Good reasons
Certificates of deposit are safe. They are FDIC-insured up to $100,000 (that's been raised to $250,000 through December 2009), which makes the principal safe from loss. With the stock market as volatile as it's been, protection of principal is almost as important as appreciation. With the markets down double digits, earning what was once a measly 4% APY on a CD looks good right now since it beats the market by a considerable margin.
The stock market is volatile. There's comfort in knowing your money is safe and earning a little bit of interest. While I'm not worried about my retirement savings, as my retirement is 40 years away, I would be hesitant to put any money I'd need in the next five or 10 years into the stock market right now simply because it spikes and craters so easily. Would you be surprised if the market jumped 700 points? I'd be a little happy, but the reality is that it might drop 700 points the next day. CDs? They just go up slow and steady, but I hear that wins races.
The rate of return isn't bad. A 4.65% APY, which was the highest CD rate as of this writing, is pretty good. It probably beats your bank's savings account rate. (If you have an online bank account, the best high-yield savings account rates are pretty good too so they're worth checking out as well.) All in all, 4.65% APY isn't 10%, the typical number used to talk about the stock market, but I think you'd be hard-pressed to make that argument given our environment.
Bad reasons
Inflation will eat your lunch. Inflation is going at a pretty good clip these days, 4.9% as of September CPI numbers, and it is the biggest problem you run into when you save with CDs. If you save at 4.65%, you're losing 0.25% of your purchasing power each year and that's before taking taxes into account. If you're in the 25% tax bracket, 4.65% APY is really 3.49% APY, which means you're losing 1.41% of your purchasing power each year. That being said, the alternatives aren't too spectacular either.
You're locked in for a set period of time. The shortest CDs are usually six months and offer the least amount of interest. The sweet spot right now appears to be the 12-month and 18-month CDs, though if you're willing to lock it in for 60 months (five years), you would be handsomely rewarded (in today's terms). With CDs, you're totally locked in. You can often liquidate a CD if you surrender a number of months' interest (often it's three months, but it varies). That's a nasty pill to swallow if you need your money.
There are better options if you are willing to accept a little bit of risk. Tax-exempt money market funds are a good place to store money and get a much better rate of return. I recently looked at a Vanguard tax-exempt money market fund and it had a tax-equivalent yield of about 6% APY. It invests in municipal bonds to earn that higher interest but it's not FDIC-insured.
There you have it, three good reasons why you should and three reasons why you shouldn't save using CDs right now. If you have any thoughts on them or maybe a point I missed, please share them in the comments.
Other articles of interest at Blueprint for Financial Prosperity:
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