Certificates of deposit, or CDs, may be lesser-known to the average American than a bank savings account, but this type of interest-bearing account is no less important than other parts of your financial portfolio. However, as the coronavirus continues to send shockwaves through financial markets and the economy, many savers are wondering what to do with their low-yielding CDs.
Unlike a regular savings account which allows you to withdraw money whenever you want without a penalty, CD holders agree to keep their money deposited for a certain length of time, earning a higher return as a result. However, if you withdraw principal from a CD early, you will incur fees.
Asher Rogovy, chief investment officer of Magnifina, acknowledges that every investment has its own “risk/reward trade-off,” but still sees plenty of merit in CDs to house your hard-earned dollars despite the fact they currently earn historically low interest rates.
“CDs are a single step up from savings accounts in terms of both risk and reward,” he says. “The increased risk is because a CD must be held to its maturity, whereas savings accounts allow withdrawals at any time.” The reward? A CD, which pays higher interest, will help you earn more on your money.
CD rates are declining
CD rates are impacted by interest rate moves by the Federal Reserve. And since the U.S. central bank’s key rate has been pegged at zero percent since March 2020 in an effort to stimulate the economy during the COVID-19 crisis, CD rates are low.
“The Federal Reserve uses the target interest rate for overnight interbank lending as a tool to manage the economy and keep unemployment in check,” says Steve Sexton, financial consultant and CEO of Sexton Advisory Group. “Consumer financial products like credit cards, mortgages, saving accounts and CDs are directly influenced by the Federal Reserve interest rate target.”
While homeowners are rejoicing over record-low refinance rates, savers have instead watched their would-be profits on their cash savings dwindle as CD rates plummeted.
The best yield on a one-year CD is currently 0.80 percent, according to Bankrate. The top rate for a five-year CD is 1.25 percent. And average CD yields are much lower.
“For many financial institutions,” Sexton explains, “interest paid to CD holders is looked upon as an expense. With banks and credit unions currently going through a period of financial stress, we’re seeing CD rates (lowered) to reduce margin pressure and stress on the loan portfolio.”
CD and savings rates could remain at historic lows “for the foreseeable future,” Sexton says.
“Low-rate environments are difficult for conservative savers looking for yield,” says Paul Weaver, founder of The Income Finder. “CDs are a favorite vehicle for those not interested in the risk of investing in stocks and bonds. Unfortunately, CD rates have continued to decline just as overall rates have.”
These ultra-low rates may stick around for a while, according to Weaver. “The Fed has indicated they plan to keep interest rates low for the near to mid-term future,” he says. “Rate hikes aren’t expected until 2022 at the earliest.”
It’s enough to make one rethink their use of CDs, but there are still times when a CD can be the most appropriate product for your financial needs.
Situations when a CD still makes sense
With low rates expected to continue, it could be the right time to seize upon a CD if you’re looking for a low-risk investment that pays more interest than a savings account.
“CDs are widely recognized as one of the safest investments,” says Rogovy of Magnifina. They are insured by the FDIC, which eliminates the risk of losing money if the financial institution fails.
Guy Baker, founder of Wealth Teams Alliance and author of The Great Wealth Erosion, agrees. “CDs are typically used by investors who want liquidity and safety in the short run,” he says. “For instance, they may have just sold a building or a business and are wary of deploying their gains right away into a new investment. They often want a safe place to park the money until they decide their next financial move.”
CDs can be a fantastic option if you’re looking to fill a short-term need — especially if you happen to benefit from pre-pandemic rates.
While most CDs earn less than the current rate of inflation, they’re still a safe place to park money.
“CDs are still a great place for short-term protected savings with the funds to be utilized in three, six or nine months,” Sexton says. “If you’re locked in a long-term CD before rates fell in March 2020, you could be in good shape for awhile.”
Weaver says that CDs can be beneficial as a retirement investment solution for risk-averse investors because it offers greater peace of mind than you may find with other types of financial investments, such as stocks which have the potential to earn higher returns but can suffer losses due to market fluctuations.
“If you’re retired, looking for yield and cannot sleep when investing in stocks and bonds, then CDs are your best option,” Weaver says. “It’s best to ladder your CDs to reduce interest rate risk. That means choosing (CDs with) different terms, so your CDs mature at different times.”
Situations when a CD doesn’t make sense
Although beneficial for some, there are some financial scenarios where CDs don’t make a lot of sense.
Dr. Baker cites a number of situations in which a CD may not be appropriate:
- Long-term investing
- Low rates
- High inflation possibilities
Money that you don’t need for a very long period of time, such as retirement savings that won’t be needed for decades, is best invested in assets with more growth potential. Dvorkin does not recommend CDs for those whose goal is to generate bigger gains on their holdings.
The rate of inflation has a huge impact on how successful CDs will be for you. The reason: your money will lose purchasing power if the amount of money you earn on your CD is less than the rate of inflation.
“Neither CDs nor savings accounts are good investments when interest rates are lower than inflation,” Rogovy says. “Today, inflation risk significantly outweighs credit risk, and most investors should look at securities with more upside potential than CDs.”
With inflation so heavily tipping the scales, it’s critical that investors and savers consider looking for investments earning more than the rate of inflation.
Your emergency fund is money that you need to gain access to at any time without paying a penalty. That’s why CDs, which require you to lock up your money for a specified period of time and have early-withdrawal penalties, might not be a great choice for your rainy-day fund.
“There’s not a strong reason to lock your money into a CD when the rate the bank pays is only nominally higher than the rate you would be receiving in a savings or money market account,” says Matt Stratman, financial adviser for Western International Securities. “Until rates go up, it makes more sense keeping your money liquid in case of emergencies.”
Instead, he offers a suggestion. “Any amount more than an emergency reserve shouldn’t be sitting in the bank earning close to 0 percent. You should aim to outpace inflation with your long-term money.”
To accomplish this, he recommends other financial vehicles that are better suited to this goal. This includes products like bonds, TIPS, annuities, and other alternatives that give better returns than CDs.
“CD’s typically offer lower rates than investing in stocks and bonds,” says The Income Finder’s Weaver. “Based on historical returns, you’re better off investing your money in the market. If you’re younger or still working, CD’s are not your best option for returns.”
Alternatives to CDs in 2021
Sexton offers a few scenarios for alternatives that are appropriate for 2021 investing::
- Fixed annuities
Sexton says an option is fixed annuities “with one-year term rates as high as 1.5 percent and five-year rates as high as 3 percent.”
- Retirement investing
“If you are looking for a retirement vehicle with better returns that are principal-protected, consider fixed indexed annuities,” he advises. “Depending on how close or far you are to retirement, you might consider shifting to funds with riskier assets, like stocks, bonds and real estate investment trust.” Fixed indexed annuities invest in more growth-oriented investments but offer downside protection.
“Depending upon your long-term strategy, investment goals and risk tolerance, bonds can provide higher yields,” says Sexton. “Real estate investment trusts could provide predictable income, and stocks may give you better returns, but all have much more risk.”
With coronavirus still in full force, it may be a while before rates increase again, making the timing less-than-ideal for those interested in a new CD.
“If you have saving accounts, money market accounts or are renewing your CD, it doesn’t make sense to lock in rates that are at historic lows,” says Sexton.
There’s hope for the future, though.
Howard of SeaCure Advisors reminds us of the support that’s already come from Congress and the Federal Reserve, saying, “These institutions want businesses and consumers to have resources available to hire and retain employees, invest in new equipment, buy goods and overall contribute to economic growth.”
As life slowly adjusts to a new normal, it’s important to remember that you still have options when it comes to your finances.
As Sexton reminds us, “You don’t have any control over interest rates, but you have the power to make smart choices about investing your hard-earned money.”