Certificate of Deposits (CDs) have traditionally been one of the most commonly used vehicles to save money. From the title, my position is clear that CDs are a bad investment. But this doesn’t come from a dislike for banks or conservative investments like CDs. My first investment actually was a CD!
Are CDS a Bad Investment?
As a 9 year old I earned money working for my older brother helping him with his paper route. And at 9, there’s not much to spend your money on. After some time, I saved up enough money that my dad thought it would be good to invest that money in a CD, which at the time paid around 5%.
I can still remember the moment when the banker took out her financial calculator to punch in the numbers to tell me how much money I’d earn over the coarse of the 6 month CD. That moment I didn’t realize it, but that is when I fell in love with the idea of investing!
Investing in CDs
I thought, “how great is it that I can put money in an investment and then just let it sit. And, after a certain amount of time, I would have more than what I started with.” I remember knowing that I didn’t need those funds right now anyway. It might as well become more money for when I do need to use it.
It’s not that I don’t like CDs. I just like making money on more than one specific type of an investment. And, if you haven’t looked at CD rates lately, you’re not missing much. The current CD rates as of August 25, 2021 are as follows:
CD Interest Rates
|6 Months CD||0.55%|
|1 year CD||0.70%|
|3 year CD||1.00%|
|5 year CD||1.15%|
I know. This is super exciting, right? Thankfully, for 9 year old me, rates were higher. Because on a $500 investment, you wouldn’t have got me in the car to go to the bank for that s**t.
Why did my dad have me invest my money in CDs in the first place? Why not invest in stocks or savings bonds?
Where to Invest My Money?
Let me dive into the mindset on generational investing and where to invest money. My dad was born in 1950, I was born in 1990. My dad started saving money in the mid-late 70s during a period of high inflation and high interest rates. Government bonds were the best investment because of high interest rates and rising inflation.
Stocks were also going through a rough period during the 70s and early 80s. But, CD rates were paying a lot. And CDs were easily accessible compared to the stock market. (Remember, the internet wasn’t around at that time. And therefore, discount brokers like Charles Schwab and Robinhood weren’t either.) CDs were one of the easiest ways for regular middle class people to save and invest.
CD Investments and Inflation
Today, the investing world is very different. Investing is almost free. There are brokers like Schwab, TD Ameritrade, and Robinhood that are easily accessible to anyone with a phone or computer. So, investing is more accessible, but what if you’re a conservative investor and you want to make sure you don’t put your investment principle at risk? And, in that case, why are CDs a bad thing in that case?
My answer: INFLATION!
Inflation is the economic term for stuff costing or being worth more. Look at the price of a cup of coffee over time:
In the US inflation has averaged about 3% over the last 100 years. Currently, in 2021, year over year inflation is extremely high because of the restart of the economy due to the Covid shut downs throughout the world.
Current rates are above 5% as of August 2021. These inflation rates will likely level off as the economy gets back to normal. But, the 2 year average inflation rate from 2019-2021 is still between 2.5-3%. I bring up inflation because, as an investor, it matters how much “stuff” you can buy with your money.
Inflation Affects Investing Decisions
Remember the reason to save and invest money is so we have it when we need money to spend or want to give it away. There are only 3 things you can do with money: save, spend or give it away. That brings me back to the topic of this blog, why are CDs a bad investment?
The short answer is inflation. If you’re going to invest money for 3 or 5 years and make 1-1.15% each year, even if you assume inflation is even 2%, that’s a guaranteed loss of 1% every year. That’s not even taking into account if that money is invested in a taxable account vs a tax deferred account (i.e. IRA, Roth IRA, etc.).
If the money is in a taxable account, you pay taxes on that 1-1.15% interest earned. So you don’t get to keep all of that, plus you can’t buy as much stuff with it because of inflation. This locks in a loss of over 1% a year investing in a CD right now.
Laddering CDs as an Investment Strategy
I’ve been asked about laddering CDs as an investment strategy before. People are either combative with the idea that CDs are a bad investment or they don’t realize how many times have changed, when it comes to interest rates.
Laddering a CD as an investment strategy is not wise! Unless you are restricted and have to invest money in government backed bonds or something FDIC insured, this is a terrible investment strategy. The reason for this is often why you are laddering those CDs in the first place. Because you have time on your side and don’t need the money right away.
Time is your best friend when it comes to any good investment strategy. The longer the timeframe, the more likely you are to make money in a diversified portfolio. And that means more compounding your money can do.
Alternatives to CDs
If you are a conservative investor, there are better options out there, as long as you don’t need the money for at least 1 year. If you need to use money within 1 year and can’t afford any risk to principle, then CDs or money markets may be your only option. But for those of you with a longer time horizon, there are investment strategies that can be implemented (with risk to principle – no risk, no reward) based on timeline to use the money, account type, and risk tolerance. These can be better options than CDs.
What determines if someone should put investment money in a CD?
The need to use the money within a year
Like I said above, don’t roll the dice if you have a short timeframe to work and are trying to pinch every penny of growth out of your money, which would risk a short term loss.
Emergency Funds Savings
This is that 3-6 month worth of expenses that should be sitting in savings. Emergency fund money shouldn’t be looked at as an investment. It should be looked at like insurance. This money is for those just in case events. And depending on how accessible the CD is, emergency fund money may fit well in a CD.
Municipalities often have restrictions on where the tax payer’s money can be invested. Many times, it’s only allowed to be invested in federally government backed or FDIC insured investments. CDs would work in this scenario, although market linked CDs may be a better option for the municipality with a longer timeframe.
You worked hard for your money. Make your money work hard for you!