5 Alternatives to CDs

Three years ago, your friendly neighborhood bank offered just about 4%, on average, to store $10,000 in a certificate of deposit. That sounded reasonable, or at least safe, so let’s say you took the deal. And given all that’s happened since then, you’re probably congratulating yourself on a wise decision. Now the CD’s time is up, and your bank wants you to re-up. But interest rates are way down. Figure you’ll collect 3% now if you lock up your money through 2014, or 2.5% through 2012.

If you make a five-year deposit at GE Capital Financial, which is FDIC-insured although it’s not a traditional bank, you can get 3.5% for five years. If you’re an absolute fanatic about CDs, you may be drawn to GE’s ten-year rate of 3.8%.

But that’s making a bet interest rates won’t rise substantially for a long time. I doubt CD rates will go up much in 2010 because the Federal Reserve Board is still under pressure to keep rates low to help the economy. But when the Fed does start increasing them, expect a quick rise throughout the banking system and the bond market.

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So as you greet the return of your CD money, you can do better than a new CD. Here are some alternatives:

Hold it in a savings account

True, savings accounts generally pay less than CDs, but their rates will also rise when the Fed hikes rates, and your money won’t be locked up. Online banks are the primary sources of higher-yielding savings accounts, with ING Direct the original and best-known provider. It’s currently quoting 1.3%. Ally Bank, a newcomer that used to be affiliated with GMAC, offers 1.5%. More good news: You rarely see minimum-deposit rules or nuisance fees to open or close an account.

Get a hot TIP

There are alternatives to the bank that pay more than CDs and do not tie up your money for a fixed period. Plus, they’re just as safe as CDs. Since this is money you’ve resolved not to lose, let’s stick with government guaranteed ideas.

U.S. Treasury securities come to mind, but to get even 3% you have to buy a seven-year bond. Well, the chance that bond yields will go up between now and 2016 is very high. If a three-year CD is a bad idea, a seven-year Treasury bond is a worse one. The same is true of shorter-term Treasuries. One year gets you 0.35%, which is way less than an FDIC-insured savings account at Ally Bank or ING Direct.

There is one Treasury offering, though, that is a reasonable idea if you’re willing to trade less income now for some protection against higher rates: TIPS, or Treasury inflation-protected securities (www.treasurydirect.gov). I haven’t been a big fan of TIPS because there can be tax complications and I also don’t think there’s been much risk of inflation during the economic downturn.

The TIPS with the shortest terms, of five years, currently yield 0.32%. (You can buy TIPS from the Treasury, through a broker or in a handful of mutual funds.) The yield is negligible, but you get paid a supplement to your principal to equal inflation each year, so if inflation accelerates during the term of the security, you keep up. I wouldn’t say that TIPS are a wise investment for high-yield portfolios or for money you want to see grow, but they’re a reasonable choice for no-risk savings, especially in an IRA.

Buy bundled mortgages

There’s also a U.S.-backed investment that pays decent yields and has held its value through all the turmoil. These are securities backed by the Government National Mortgage Association packages U.S.-guaranteed home loans into investment securities that trade like bonds but yield much more than the Treasury securities. Ginnie Mae has the full faith and credit of the U.S. government, which is unique among mortgage investments.

You can buy GNMA, or Ginnie Mae, securities through brokerage firms, but the easiest and soundest way to participate is through a mutual fund. We recommend the no-load funds from such providers as Vanguard, Fidelity, T. Rowe Price and Pimco. Currently these funds yield about 3%, pay interest every month, and vary little in share price -- maybe a penny or two or three each day on a price of about $10. That’s close enough to a CD for all intents and purposes. And if rates rise and you want to lock in a fixed yield somewhere else, you can just sell these funds.

Buy something

Spare me any sermons about Americans’ extravagant spending habits and the virtue of thrift. This is a good time to be a buyer. The marketplace for goods and services abounds with superb values. That’s not only true for a netbook or a flat-screen television, but for once-in-generation expenses from elective surgery to a custom-built titanium bicycle. Of course, you should splurge only if you have at least three months of expenses in an emergency fund and you have no problems paying your bills on time.

Buying with cash is especially sensible if your alternatives are taking out a personal loan, using a credit card or suspending contributions to your retirement account.

Extinguish debt

Debt reduction could be the wisest use of all for that CD money. It’s certainly sensible to take $10,000 that may earn 1% in a bank and wipe out a credit card balance that costs you ten times that much. But even if you don’t have high-rate debt, think about this. For example, $10,000 could do some real damage to a mortgage.

Let’s say you owe $250,000 on your home at a fixed 6% for another 25 years. If you reinvest $10,000 in a CD for three years at today’s rates, you’ll end up gaining about $800 in interest. Instead, take the CD money, throw $300 extra into your monthly mortgage payment until the money runs out in about three years. This shortens your mortgage by two years and saves you $29,000 of interest. (Test your potential savings at www.mtgprofessor.com.) And if it prompts you to go on prepaying the mortgage, you’ll own your house free and clear even sooner.

A personal-finance purist might argue that if you invest that $10,000 in a successful mutual fund, you’ll get a higher return. But I’d say CD money should go for a sure thing before it belongs at risk in the stock market or something even riskier.