For 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)

I discovered this detailed real estate blog called Matrix and this incredible set of mortgage-related heatmaps used by Bernanke in his last speech. Heatmaps are the quickest way to get a “snapshot” of a situation and these go through so many permutations that you can get a really good sense of what’s going on (and there are so many maps!). I had no idea unemployment concentrations were dispersed the way they are and how badly hit the Michigan area has been lately given the major auto manufacturer’s financial woes.

My last employer recently offered a Roth 401(k), which is essentially a tax-free version of the tax-deferred 401(k), though employer contributions are tax-deferred. It’s an interesting concept that has been around for a few years but hasn’t been adopted too widely, probably because of the paperwork. If I had a choice, I’d split my contributions evenly between the two and give myself some diversification.

Trent has received numerous complaints that he writes about the same stuff over and over again and that it’s getting old. Unfortunately for all you excitement hounds, personal finance is repetitive, it is conceptually easy, and “slow and steady” does win the race. It’s the chase of excitement, having that fancy car so you can drive it fast, throwing some money at a high flying potential stock, or that huge flat panel television -I that’s the stuff that derails your trek to your personal finance goal. Spend less than you earn, contribute to your 401(k) and save for retirement, ensure you have proper and adequate insurance, blah blah blah – it’s repetitive but it works. Michael Jordan once said he shot a thousand free throws a day. How’s that for repetitive?

Nickel wrote a bit about his asset allocation this week and it’s something I am hoping to review sometime next week. I’ve input all the data I have into Vanguard’s Portfolio Watch and now I just have to figure out what my goals are so I can set things up correctly once and for all.

Housing doesn’t always go up. Sometimes it comes down. Hard. (scroll down to the story of the house that sold for $505k in 2006 and is now on the market for $177,495 – ouch)

Lastly, if you like heatmaps and those first dozen weren’t enough, here’s a cool one about all the pieces of inflation on the New York Times, my new BFF, courtesy of Consumerist (who got it from Nathan). Not surprisingly, that big red area is gas.

Have a great weekend!

When the Fed drops its federal funds rate, economists across the world shudder as they see the spectre of inflation peer over the horizon. You ever wonder why that is? The answer is quite simple but will come in two parts. First, a brief refresher on supply and demand, followed by how that and the Fed’s lowering of rates may bring on inflation. Before we begin, I want to make note that everything has been simplified from what’s actually going on. Everything is very complicated in reality but you can explain the gist fairly easily if you’re willing to take some liberties. Those who have a background in economics and know all the intricacies will see some inaccuracies, but they are there to make the explanation smoother. A basic understanding is far better than none at all.

Supply & Demand 101

Simplistically, economists believe that supply and demand will dictate price. If you have more supply with the same demand (surplus), the price goes down. If you have less supply with the same demand (scarcity), the price goes up. If demand goes up with the same supply, price goes up, and vice versa. You’ll see this represented with supply and demand “curves” with the price at where the two intersect. There’s far more to it than that but that’s enough to go on. (it’s actually quite cool if you’re interested, google up some more info)

Fed Target Rate

When mainstream media folks talk about the Fed lowering the federal funds rate, what they’re really talking about is the Fed lower its target rate. The Fed is like a puppet-master and the banks are its puppets. When the Fed says it wants to lower the target rate, it’s really saying that it’s going to be putting more money into the market to lower the cost of it. It’s like a puppetmaster putting on a good show, a twist of a finger here, a lift of the wrist there, and before you know it you have yourself a Broadway musical. The Fed’s “twist of a finger” is sending additional funds to banks that may be low on reserves.

Inflation!

Ideally, the target rate drives the Fed to only put as much additional funding as is needed to keep the economy humming along and banks able to fund their work. Unfortunately, there’s a lag between when the Fed begins acting and when the effects take hold. The fear of inflation is founded in the fact that if the rate is set too low and too much additional funding is pumped into the system, banks find themselves with more than they need.

What happens if they have more money than they need? They lend it out at cheaper prices! (more supply than demand) When consumers get more money, they will spend more money. When they spend more money, demand on goods and services will go up. As demand increases, sellers of products and providers of services will increase their rates… which is inflation.

Inflation is not bad. Moderate inflation is normal and expected. It’s a sign that goods and services are in demand, consumers are financially strong enough to support increased prices, and a signal that the economy is strong.

High inflation is bad. It’s bad because it hinders economic growth. When inflation is high, investors will demand higher rates of return for their savings and so borrowers of money, business and such, will have to pay more to borrow money. If they pay more, the pace of growth slows down. The economy slows down, inflation will settle, and we continue the cycle all over again.

That’s (simplistically) why the Fed lowering rates can lead to high inflation.

Let’s say you have a $25,000 student loan (what a coincidence, I have a nearly $25,000 student loan!) on which you’re paying about 3% interest, if you consolidated about two years ago, and you’re only sending in the minimum payments because you’re coming out ahead when you deposit the rest in a 5.15% Emigrant Direct account. This is exactly what I’d be doing if my loans weren’t in deferment because of my continuing education. (feel free to substitute car loan for student loan in the example, any low interest loan will suffice)

The only problem with that thinking is that while you are you coming out ahead by 2.15% (a little more considering the interest deduction), the difference between the 5.15% savings account and the 3% student loan interest, you’re actually falling behind from a purchasing power perspective because inflation is higher than 2.15%!

Now, if we were discussing this, you’d say that if you paid out the entirety of the loan as quickly as you could, you’d in fact be making 0% on that money because you would no longer possess it. That is true, however, by accelerating your payments you are setting yourself up to be debt free in the future and thus able to freely invest what you would’ve had to earmark for student loan payments. [Also remember that this superficial analysis ignores all other factors because we often can't make large payments on our student/car loans because we have other financial obligations like mortgages/rent, food, emergency funds, etc. that take precedence, but for the sake of argument from a strictly mathematical perspective I ask that you leap with me.]

So, how is this different than the 0% balance transfer arbitrages that many personal finance bloggers (including myself) have started? How does a 3% car loan differ than a 0% credit card loan outside of the interest rate? The difference is the 0% balance transfer is the source of the interest bearing funds whereas with a car loan the source of the interest bearing funds are your own savings. 0% balance transfer money is a bonus.

I’m eager to hear everyone’s thoughts on this because for the longest time I was of the mindset that you should just pay the minimums, deposit the rest, and collect your difference in interest because you’re making more than 0% on your money. The floor of what you should demand on your money should be the inflation rate, which is much more than 0%.

Don’t expect to see that on a t-shirt or anything (let me know if you do!) but inflation is hurting our poor defenseless pennies. We all know what inflation is, but most of us don’t really think about it on a daily basis; even when we’re making our most important financial decisions. It’s those stories you hear about a pack of gum cost 5 cents back in the day and now they cost fifty cents or more; that’s inflation, or the erosion of our currency’s purchasing power.

Let’s ignore the bigger macroeconomic issues as to why inflation exists and whether it’s good or bad, because honestly I don’t think most people care. We can let economics and policy makers analyze those aspects because it matters to them (it better!). For us little people, let’s talk about how they measure inflation. There are two indexes (indices if you prefer) most people talk about: the Consumer Price Index (CPI) and the Producer Price Index (PPI). They are the big indicators and the US Bureau of Labor and Statistics tracks them both. In summary, the CPI tracks price changes with respect to the consumer and the PPI tracks them with respect to the producer. They say in the long run the two trend similarly but in the short term the PPI will lead the CPI (which follows intuition, producers raise prices before consumers feel them). Well, when the Federal Reserve meets (8 times a year) to decide whether or not to adjust the short term interest rates, the CPI/PPI is a factor they take into consideration.

Well, how does this affect me/you? Basically, your investment’s true return is really its stated return minus inflation and taxes. Nearly everyone accounts for taxes because you take money out of your pocket. Inflation is an invisible tax because you’ll just lose purchasing power, not actual dollars.

But I don’t invest a lot of money; where else will this affect me? Your salary! Are you happy with that 2% raise? You would be if everyone around you also received a 2% raise (or less), but what if I told you the historic rate of inflation was 3.257% since 1913 (according to the inflation calculator on the USBLS website)? That meant if our rate of inflation this year were 3.257%, you actually took a purchasing power pay cut of 1.257%!

We arrived at 3.257% because in the 92 years since 1913 (to 2004), $100 (1913 dollars) is now worth $1908.08 (2004 dollars), or a 3.257% annual increase.

How do the interest rates of ING Directrel and Emigrant Direct sound now? How about that bond? When you have to beat 3.257% CPI-based historic inflation rate, it doesn’t look as appealing huh? Look at some of the actual historic rates and you can see that in some years the rates were much higher (though you would expect rates of return for CDs, bonds, and the like to be much higher as well). So think about the rate of inflation next time you make any sort of financial decision, it’ll open your eyes.