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Certificates of Deposit: Pros & Cons Weighed

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Hiding Piggy BankFor the last ten years, certificates of deposit have gotten a terrible rap. Interest rates were low compared to the blockbuster returns of the stock market and you were locked into that CD for 12-, 24-, 60- months, all making it an unappealing investment option. For many, CDs only ever came up in financial conversation when you were talking about laddering an emergency fund because protecting your principal was your number one goal.

Well times have changed and CDs, with their FDIC insurance, have once again come into vogue as investors have plowed hundreds of billions of dollars into the CD market in recent weeks. I personally use CDs to help increase the rate of return on my savings, specifically in laddering my emergency fund, and below I will list three good reasons you should save with CDs and three reasons why you shouldn’t.

Three Good Reasons

Certificates of deposit are safe. They are FDIC insured up to $100,000 ($250,000 through December 2009) which makes the principal safe from loss. With the stock market as volatile as it has been the last several weeks, protection of principal is almost as important as appreciation. With the markets down double digits, earning what was once a “measly” 4% APY on a CD really looks good right now since it beats the market by a considerable margin! The best CD rates are now in the mid-4% APY range so they are at least competitive with other options.

As I mentioned earlier, the stock market is volatile and there’s certain comfort in knowing your money is safe and earning a little bit of interest. While I’m not worried about my retirement savings, as my retirement is forty years away, I would be hesitant to put any money I’d need in the next five or ten years into the stock market right now simply because it spikes and craters so easily. Would you be surprised if the market jumped 700 points? I’d be a little happy but the reality is that it might drop 700 points the next day, with seemingly no rhyme or reason. CDs? They just go up… slow and steady, but I hear that wins races.

Lastly, the rate of return isn’t bad. 4.65% APY, which was the highest CD rate as of this writing, is pretty good. It probably beats your bank’s savings account rate. If you have an online bank account, the best high yield savings account rates are pretty good too so they’re worth checking out as well. All in all, 4.65% APY isn’t 10%, the typical number used to talk about the stock market but I think you’d be hard pressed to make that argument given our environment.

Three Bad Reasons

Despite their relatively high, and safe, returns, inflation will eat your lunch. Inflation is going at a pretty good clip these days, 4.9% as of September CPI numbers, and it is the biggest problem you run into when you save with CDs. If you save at 4.65%, you’re losing 0.25% of your purchasing power each year and that’s before taking taxes into account. If you’re in the 25% tax bracket, 4.65% APY is really 3.49% APY, which means you’re losing 1.41% of your purchasing power each year. That being said, the alternatives aren’t too spectacular either.

With CDs, you’re locked into a set period of time. The shortest CDs are usually 6 months and offer the least amount of interest. The sweet spot right now appears to be the 12 month and 18 month CDs, though if you’re willing to lock it in for 60 months (5 years), you would be handsomely rewarded (in today’s terms). Fortunately with CDs, you’re totally locked in. You can often liquidate a CD if you surrender a number of months interest (often it’s 3 months, but it varies). That’s a nasty pill to swallow if you need your money though.

Finally, there are some better options if you are willing to put your money in a little bit of risk. Tax exempt money market funds are a good place to store money and get a much better rate of return. I recently looked at the Vanguard Tax Exempt Money Market and it had a tax equivalent yield of around 6% APY. It invests in municipal bonds to earn that higher interest but it’s not FDIC insured.

There you have it, three good reasons why you should and three reasons why you shouldn’t save using CDs right now. If you have any thoughts on them, maybe a point I missed, please share them in the comments.

(Photo: corrieb)

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4 Responses to “Certificates of Deposit: Pros & Cons Weighed”

  1. HokiePerogi says:

    I was wondering where you saw a tax equivalent yield of around 6% for the Vanguard Tax Exempt Money Market fund?

    Using the compound yield of 3.24% on Vanguard’s fund information page and applying a 28% tax bracket, the equivalent is only 4.5%.

    Even at the “Since Inception” yield of 3.87, that’s only a tax equivalent yield of 5.375%.

    Am I calculating my number wrong or pulling my data from the wrong source?

  2. kitty says:

    You can also buy municipal bonds directly. With the current credit crisis there are some attractive yields on AA and AAA municipal bonds. Sure it’s not insured, but the probability of default with AAA bonds is low. I just bought a NY State AAA 10-year municipal bond with 5.38% tax free yield to maturity (YTM). Sure it’s 10 year, but if interest rates go down, the resale value will go up. I also saw municipal bonds with 1- and 2- year remaining to maturity with tax free YTM of over 4%. In my tax bracket it’s pretty nice. Last week was better – I guess because of tighter credit – but I needed time to transfer cash to my brockerage account….

    Unlike Vanguard money market, if you buy individual bonds you lock in the rate whereas with money market the rate is variable. Also, with individual bonds you have an option of waiting to maturity.

  3. Actually one could create a CD ladder by utilizing a variety of maturities out there. I like CD’s because you are locked in and know how much money you have. With savings and checking accounts you can always check it and have the tendency to withdraw money for things you don’t want to spend on.

  4. Dandilion says:

    howmuch should i invest


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