In an economic climate marked by rising interest rates, there is a renewed interest in certificates of deposit (CDs). But with trust in banks dwindling and convoluted reserve requirements, the question persists: Should you invest in CDs?
Like most things, it depends on your needs and goals, but most of all, it is important to understand the product you’re placing your money into before choosing to deposit money into a CD. I understand that a bank CD may seem as basic as the ABC’s, but I find that many people have little knowledge about why banks issue them, how they are used and how they are priced.
This may not seem all that important, but the truth of the matter is, it is and has a lot to do with building wealth. Because wealth isn’t created by buying a CD based on a rate, it is created by understanding why the rate isn’t all that important.
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Competition on rates
I live just south of St. Louis, Mo., and like many rural communities, there are banks and gas stations at every corner, seemingly right on top of each other. As I drive around town, I see banks promoting their rates on digital boards like gas stations posting the price per gallon of fuel.
One bank increases its rates, and it seems like all the other banks follow suit and raise their rates, but there is more to this than banks watching to see what the bank down the street does to stay competitive.
Banks use the federal funds rate, also known as the benchmark rate. This is the rate banks charge one another to borrow money overnight that’s needed to maintain reserve requirements (though the reserve rate is currently at zero).
Further upstream in the decision-making process is the Federal Open Market Committee (FOMC), who meet throughout the year to discuss and set monetary policy. Within these policies, rates are set and are mostly linked to inflation. When rates are set, banks may adjust rates on loans, deposits and CDs, but just like any business, banks will adjust rates to compete in their market as they seek to cover their costs and maintain a profit.
They use rates to attract more customers to help expand the number of depositors they have, which is an indicator of growth, and the added deposits help cover the loans they originate.
CDs specifically are an attractive tool for banks because, unlike a deposit account, CDs lock customers up with maturity dates, which gives banks better control of their cash flow.
Customers are drawn to the higher rates as they seek to maximize their returns, but when you look at the math, the rates really don’t matter. Okay, they matter some, but they don’t matter as much as the difference between inflation rates and interest rates. Here is why: If inflation is running at 7%, and interest rates are at 5%, the net of this is 2%, and if inflation is 2%, and rates are zero, the spread is still 2%.
It is easy to get enthusiastic about higher interest rates on deposits, but we can’t take our eye off the ball. Inflation is the enemy. It is the headwind that erodes our purchasing power, and it is not the rate that matters as much as the net of return after inflation.
From a debt standpoint, the increase in rates is impacting lending, and when you consider the gridlock within the housing market and the amount of debt our government holds, it is hard to believe rates can remain elevated for long.
The government is desperately trying to combat inflation by raising rates. The Fed has a 2% inflation target and wants to see unemployment higher, which doesn’t make sense for the average person, but it is all about price stability.
When there are more jobs available than unemployed workers, theoretically everyone could have a job, and with that, people spend money, but if the economy cools, business in theory would stop hiring, and with higher unemployment, spending slows.
The effect on government debt
But here is the deal: These higher rates not only impact consumers but our government. The Congressional Budget Office (CBO) in June projected that annual net interest costs on the federal debt would total $663 billion in 2023 and almost double over the upcoming decade. Interest payments would total around $71 trillion over the next 30 years, taking up to 35% of all federal revenues by 2053. These numbers are impacted by interest rates, and with lower rates come lower interest payments.
Regardless of our opinions, theories and preferences, we know that the economy runs in cycles, and the cycle we are in will transition at some point. So, while rates are high, does it make sense to lock in CD rates? If you have money sitting in a bank account that you don’t need, and the offered CD rate is higher than the rate on the bank account, then I would consider it as an option.
If you think rates are going to continue to rise, then you would want to stick with shorter maturity dates, but if you believe rates have topped out, then locking in a longer-term CD could make more sense.
It would be advisable to look at money market rates and fixed annuities to compare rates across the board, as these types of accounts often share similar rates, but there are differences to understand before deciding. Here’s a rundown:
Bank certificates of deposit (CDs) are offered by banks as a savings account that offers a fixed interest rate over a specific period.
- Have a holding period from one month to five years
- Higher than regular savings accounts but usually lower than stock investments
- Removing funds before the term ends results in penalties
- FDIC-insured up to $250,000
- Available in different types, like jumbo CDs and step-up CDs, each with their own rules
Fixed rate annuities are financial products issued by insurance companies that offer a fixed interest rate over a specific period.
- Offer a guaranteed rate of return for a specific period
- Your initial investment is protected and will not decrease
- Early withdrawals usually incur penalties or fees
- Interest earnings are tax-deferred until you start taking distributions
- Backed by the claims-paying ability of the issuing insurance company
- Has protections like FDIC through state guaranty associations
Money market funds are issued by financial institutions and are backed by highly liquid, short-maturity investments.
- Maturities usually range from overnight to just under a year
- Assets can be quickly converted to cash with minimal loss of value
- Generally considered less risky compared to stock markets or long-term bond markets
- Underlining investments include such things as Treasury bills, commercial paper, CDs
- Rates are often comparable to CDs
- Sensitive to changes in interest rates and monetary policies
Navigating the financial markets can prove to be a challenge, especially during times of uncertainty, but while CDs offer the safety of fixed returns, they are not devoid of risks and limitations. It's essential to understand both the micro- and macroeconomic factors that affect CD rates before diving in. As always, a balanced portfolio features a mix of different products and strategies and can be the most prudent strategy in times like these.
By working with professionals who are keeping an eye on economic indicators and who understand the implications of various government decisions, you can make informed decisions about where to invest your money.
To learn how to make informed decisions regarding which investments to choose, which options are appropriate for your situation and where to look, check out the free resources at my website, brianskrobonja.com.
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This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.
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