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Everyone knows you have to compare CD rates in order to get the best deal, but for many consumers that is where all their knowledge of CDs ends. Since an informed consumer is a powerful consumer, here are a few other CD facts you should know:
There are two primary reasons that CDs are not appropriate for long-term investments:
Your yield on any investment is the return you make on your principal. When you compare CD rates you are looking for the rate that will give you the best yield on your investment principal. Since CD rates are so low, they offer a low yield compared to many other investments likes stocks and bonds. When you invest money over a long term, you should be looking for a yield that is comparable to both the length of time you invest the money and the risk tolerance you have. CD rates rarely offer a yield that is high enough.
Interest Rate Risk
The interest rates in CDs do not vary. Once you buy a CD it is for a fixed rate and term so even as interest rates are getting higher or lower in the real world (and in new CD issues) your CD's interest rate will remain the same. If you buy at the wrong time, that could mean you are stuck with a low interest rate that is not competitive with current rates for a very long term.
As people edge close and closer to retirement age, they begin to long for fixed, low-risk investments to put their money in. After all, it is much harder to recover from an investment loss experienced at age 65 than one experienced at age 35. At 35, not only do you have time for the market and your investment to rebound but you also have many more years ahead of you to increase your earnings. At 65 you are definitely at a disadvantage.
As you begin to transfer out of high-risk positions in your retirement, it is not a good idea to leave your cash uninvested. Instead, you might consider doing some CD rate comparisons to find an attractive interest rate with a CD term that you feel you can stick with. Remember, you will be penalized if you take money from the principal of your CD before the term is up so be sure to leave enough cash or other highly liquid investments in your retirement account to cover any required minimum distributions (RMDs) you may have or any emergency cash needs you could encounter.
When you are looking at CD rates, it can be difficult to visualize the real dollar difference between two interest rates. Because you are not able to see the dollar difference between a 1.5% interest rate and a 2% interest rate you may assume that the rate difference is not a big deal and could lose out on potential growth.
A CD rates calculator can give you the actual calculations on return for each of the interest rates you are comparing so that you get a real understanding of the potential differences. This will help you make an informed decision based on hard numbers rather than assumptions.
For example, let's say you have $10,000 to invest in a 12 month CD. One bank has a 1.5% interest rate and the other has a 2% interest rate and each has interest that compounds monthly. At the end of 12 months you would have earned $151.04 in interest in the 1.5% CD and $201.84 in the 2% CD. That is a difference of more than $50.
While you compare certificate of deposit rates, you must consider the penalties that go along with them. You see, in order to offer a high interest rate, banks and financial institutions expect you to keep your money invested in the certificate of deposit for the entire period you initially agreed to. So if you agree to a 5 year CD with an interest rate of 3%, the bank is only able to give you that 3% because they know they can invest your money on loans for at least 5 years.
If you should decide to take some of your certificate of deposit principal out before the 5-year term ends, then the bank is not going to pay you a 3% return. Instead, they are going to apply a penalty to the funds you take so that your yield is reduced. When you compare certificate of deposit rates, if you look only at the interest rate of the potential certificate of deposit then you are only getting part of the story. Instead, evaluate your potential purchase on both the interest and the penalties as well as your potential ability to leave the money alone.
There is no such thing as a risk-free investment. Even something as low-risk as a CD carries with it some risk. This is something you must keep in mind when conducting a CD interest rate comparison.
Interest Rate Risk
The biggest risk associated with CDs is called interest rate risk . Interest rate risk is the general risk that you could get locked in to an unattractive interest rate while outside rates increase. Interest rates offered on CDs are determined by many things including the general interest rate environment (which is driven by the Fed rate) and the credit environment. When interest rates are high and credit is flowing, CD rates will generally be high. But when interest rates are lowered in an effort to get more people borrowing and credit isn't being extended, CD rates will be lower because banks can't make as much money on the cash. If you lock yourself in to a 5-year CD at a low rates and during that term interest rates increase so that new CDs have a much more competitive rates, then you are suffering the effects of interest rate risk.
So keep this risk in mind as you do your CD interest rate comparison and determine how long you want to be locked in to one rate.
|Jennifer Mathes, Ph.D.|