Certificates Of Deposit Aren't Risk-Free
With the stock market gyrating wilder than a dashboard hula doll, you probably want an investment that won't depress you when you open the paper. Certificates of Deposit or "CDs," an insured savings account with a guaranteed interest rate may sound like the antidote, but even they are not without risk.
Certificates of Deposit are great savings tools because you can get a guaranteed interest rate for a specific period of time. Unlike savings accounts, which can change their rates at will, CDs are contractual obligations that cannot change without your permission. They are very stable but they aren't without risk, here are three that you should be aware of if you're thinking about CDs.
Inflation risk is the greatest risk you face when you deposit funds into a certificate of deposit. Since the interest rate is fixed and because there is a penalty if you withdraw funds before maturity, inflation can invisibly erode your savings. Interest rates on certificates of deposit are already fairly low, because your principal is protected by FDIC insurance, so they are especially susceptible to inflation. If you lock yourself into a multi-year CD and inflation or interest rates rise, you may find yourself holding onto a CD that is costing you money. The real kicker is you'll have to pay a penalty to close the CD and access your money!
Bank failures aren't a huge deal when it comes to CDs but it can play a factor if you aren't careful.
It's important to understand FDIC insurance coverage limits because many people learned, the hard way, that part of their CD may not be protected if they are near the limit. This is less of a risk now that the limit is $250,000 but before they temporarily raised it, people were discovering that part of their CD wasn't protected. If you deposit funds into a CD and the interest it accrues exceeds the FDIC coverage limit, then the overage isn't protected. Fourteen banks have already failed in 2009, joining the twenty-five banks from 2008, this is a tangible risk.
Another risk associated bank failure is that the new bank may not honor the terms of the CD. Banks often jack up interest rates to boost their deposits and the receiving bank is not required to honor those terms (if a bank buys another bank, then they are required to honors those terms; if they receive it through the FDIC, they don't have to honor the terms). You may think to yourself - "So what? I'm FDIC protected; if they don't honor it then I go elsewhere." That is true. However, if you consider the time you lose transferring your funds around, time your funds aren't earning interest, then it has a real cost to you.
CDs are a safe investment but they aren't entirely without risk, be sure you understand these three before you open one.
Jim writes about personal finance at his personal finance blog, Bargaineering.
(Photo: spinadelic)
Post a comment
Comments:
no, just twelve different accounts at the same bank. My understanding is that each account is insured separately.
@BuddyHinton: I am accepting donations so you only have to split them amongst 11 banks. Fewer if you like :)
If you have a CD and want to make sure all of it is FDIC protected, you don't have to start accounts at 12 banks. Find a bank that is in the CDARS network. Banks can join and spread your money over other banks in the network, but give you just one statement so you know how much you're making from the CDs. If something goes wrong, you're covered.
Who expects to make any money in the bank? It's all about not losing any money. It sounds like CDs aren't any better than a stupid savings account, both in safety or earnings. It really feels like "why bother?".
Thanks for the alarmist title! A basic econ course told me more than this post did. I don't see inflation being a problem in the near future anyway.
@plasticbiker: Ding ding ding! Wrong. Different banks. The point is to spread the risk around and that wouldn't happen if they were all at the same back.
This is depressing to read, especially in the midst of a snowstorm. It really feels like a winter that never ends.
@Landru: Well, it's better than stuffing the money in your mattress. And the theory is that a CD will offer a higher rate and a guaranteed one at that, something that a savings account will not do. I guess it all depends on what you're comparing the CD to.
The CD has two advantages. One is that the interest rate is likely higher than a savings rate to start with. Yes, savings rates may rise higher than your CD rate. But, for awhile, the CD rate stayed much higher than the savings. It largely depends on the economy level.
The other advantage to a CD is the fact that there is a penalty for early withdrawal. (Not much one one, really, based on my experience.) What this means is: You have savings that is not easy to touch. Not hard, just not easy.
Example: "Oh, gee, I'd love to go to this great restaurant, but my checking account is low. I'll just tap my savings account and I SWEAR I'll put it back later." Wise, no, but not uncommon. With a CD, you can't do a light borrow. But it can be "I need money for auto repairs, or to repair my clavicle after that accident".
@HarcourtArmstrong: i have to agree. this article is disappointing. inflation effecting a 6 month - 2 year CD? its not very likely. and if you are banking with an institution that is not FDIC insured you deserve whatever you get.
@Landru: Ding ding ding! Wrong. Differently titled accounts. $250K in the name the husband, $250K in the name of the wife, $500K held jointly at the same bank would all be fully insured.
Risk implies loss of money, which in most people's view would mean the loss of the principal. But the principal is safe (within FDIC limits), so therefore the only loss potential is failure to pay full contractual interest or being inconvienced.
Doesn't sound like a lot of risk.
@tobedetermined: It's just starting to get hot here in the Phoenix, Arizona area -- this week it's supposed to hit 85F!
@plasticbiker: There are a limited number of ways to get more than the maximum per account coverage at a single bank. The key is how the accounts are held. Joint accounts are different than non-joint accounts, and each gets its own coverage.
So, a husband and wife can get 3 X coverage in a single bank by holding three accounts: 1 in the name of the wife, 1 in the name of the husband, and 1 jointly wife/husband.
So, in this case, you could do 4 banks, each with 3 seperate accounts.
Note: it is actually a bit more complicated than this in that retirement and a few other kinds of accounts are also treated seperately. Check out the FDIC web site for details.
Um newsflash....where can you park your money besides federally insured accounts and be at LESS risk than a CD? Um that's right, NOWHERE!
Newsflash #2, inflation isn't really an issue at the moment, though I think short term CDs are a good choice.
Why I love GMAC CD's:
1.) Decent interest rate (relative to other CDs)
2.) They send you checks each month for the accrued interest
@cabjf: Funny thing is, My ING Direct CD actually offers a LOWER rate at the moment than my Savings Account in the same bank.
Sure, CDs will guarantee me the return, and savings rate MIGHT fall, but at 1.75 and 1.85, its not going to make much difference.
So instead of putting money in a CD that earns more than my savings account, I can let it burn a hole in my pocket and earn nothing while waiting to get robbed. Or I can invest it in the stock market and lose half right away. Decisions decisions.
@catskyfire: Just what I was thinking. But I am not too comfy with locking away my money, esp in this economy when I might have to dip in. Its not a problem as long as I have a job, but fingers crossed....
I'd be careful about the $250,000 insured level with CDs though. While that is the current level of insurance, it expires on Dec 31st of this year. No one knows whether they will keep it at 250, or lower it back to 100,000. So beware of that possible risk when getting CDs with a maturity in 2010 and beyond.
Well, I don't have anything approaching $250k, so I'm safe, even if all my money is in the same bank (forgoing a bank failure of course, but USAA hasn't been in the papers *at all*)
If you have 3 million in cash you should probably be managing your investments more wisely anyhow.
I have a bunch of 1 year CDs on rotation (about 9 of them). So there's always something that's going to re-up to the new rates.
/and the interest from the ING CDs, gets skimmed off the top each month and deposited into an ING savings account (otherwise, that interest would be sitting in the CD and not earning money since ING CDs compound yearly).
I can't wait until deflation kicks in and my 'stuff a mattress with cash' strategy starts earning a positive return!
@Lucifer_Cat: Depending on how you expect to dip in, a CD isn't necessary to bad in terms of fees. For Wells Fargo in Nebraska, it's a minimum of $25, but otherwise is loss of interest earned, not principal. Depending on where you go, amounts required are different.
@Yossarian: You only get over $250,000 there by having multiple people. If you are single for example, you can't break the $250,000 line.
For example, I am legally prohibited from being married in 49 states. So I cann't qualify for the higher levels. Well, that and I don't have over $250,000 in cash.
Now all I need is a hubby and a few hundred thousand dollars. Ah dammit.
Watch out for the fine print in the terms agreement. Sometimes if an issuer doesn't like the way interest rates are going, they can simply cancel your CD, cashing you out before the maturity date.
Better than a CDs? A Savings account in a Canadian Bank?
@catskyfire: Plus the early withdrawal penalty is tax deductible, making it even less of an issue in an emergency.
@ScottRose: What's better than an FDIC-insured bank account now? It wasn't that long ago that the yield on Treasury bills was negative because big investors didn't have anything else they had confidence in.
@catskyfire: I don't know if banks still do it, but a few years ago I was able to borrow against my CD at a rate that was cheaper than the early withdrawal penalty. (I either failed on noting the tax deduction or it wasn't going to help me.)
@Corporate-Shill: The problem is that if most people think that way they're wrong--there's risk in losing the value of your money as well as losing the amount. As noted, inflation isn't likely to be a real issue in the next 24 months or so for a shorter-term CD at the moment, but in general, there's a considerable risk in low to no-interest accounts that your money will be worth less when you take it out than when you put it in.
But behavioral economics suggests, as you intimate, that we suck at grasping that, so off we go to buy our forever stamps now :).
@Oranges w/ Cheese: Though I'm intrigued by these banks that jack up interest to get accounts over that level. If any of 'em will turn 1k into 250k, I'll take that chance!
The bailout madness and printing too much money will destroy the value of your "insured CDs" when hyperinflation takes over in the next few years. Thanks for nothing, Obama.
@Lucifer_Cat: CDs also have different amount of months it's locked in, I think, so it's possible you can invest your money with a lower rate but you can pull it out every 3 or 6 months and that might make you feel better.
I have a risk free Bank of America CD which 2 years ago had an interest rate of 5.45% (yeah), but now is down to 1.75%(argh). If necessary I can withidraw funds without a penalty as long I transfer the money to another B of A account first and then withdraw it, (checking, savings, etc.) Each term is 6 months and after 6 months you have an option to add additonal funds to the CD prior to starting a new term. While in college this was a great place to stash my savings and excess money received from financial aid, but since regular savings account ineterest rates are so low, I stash most of my cash in a CD account to earn a better rate of return.
@kingmanic: Well, the currency exchange rates may not always benefit you. Since the US dollar is considered a "safe haven" (relatively speaking), especially now that the Japanese Yen looks like it might have peaked vs. the dollar, storing your money in a Canadian Bank has its share of unique risks.
I never personally go past 6 months with a CD. 1, I might need the cash soon, 2, I can change with the inflation. Sometimes you win and sometimes you don't, but having access to my money is very important to me. I saw trends in August of last year. I knew interest rates were going to go down. So, I put a bit of cash in an ING CD at 3.65% which matured yesterday. Now, that same CD is I think 1.75%. For me, I'll keep it in my savings account and wait until it goes up.
@huadpe:
You can gain insurance coverage by adding beneficiaries on an account as Payable on Death. (Just remember, if something happens to you, your beneficiary designation is a legally binding contract regardless of what you may have designated elsewhere, such as in a will.)
@catskyfire:
Some banks (at least the one where I work) will waive the penalty in certain cases, so if you did indeed come in with a busted clavicle after an accident and needed the money for hospital bills, we'd waive the penalty.
@MargotAsteria:
Bill HR 1106, the Helping Families Save Their Homes Act of 2009, while it may never get out of committee, has a provision in it for keeping the insurance level permanently at $250,000. So even if this one doesn't pass, it shows it's at least on the radar and under consideration.
@MargotAsteria: You raise a very important point that is typically overlooked.
If, for example, you sign-up a $150,000 1 year CD today, only $100,000 of that will be covered by FDIC insurance after December 31 2009. So if the bank fails in, say January of 2010, you're exposed to the tune of $50,000 plus whatever interest accrued.
Ways to mitigate this are to open accounts at different banks, or title accounts at the same bank in different ways. For example, if you have an account in your name, one in your spouses name, and a joint account, each of those is covered separately by FDIC insurance, even if they're all at the same bank.
With all that said, I think CDs are a great investment in this market.
You guys are telling me that I've got to split my savings amongst 12 different banks now? What a pain....