By: Dustin Javier, CFP® AWMA®
CERTIFIED FINANCIAL PLANNER™
CDs (Certificate of Deposits) are considered to be very safe investments and are commonly sold at banks and credit unions. Conservative baby boomers like my own mother find many CD traits appealing because of the safety and fixed rate. However, in this short article I will go a little deeper into why I find CDs to be a questionable investment based on how they are built today. A CD investment can be a sensible strategy for a retiree yet like every investment there are pros and cons to consider. In this article I am going to review those pros and cons and most importantly, share other short term investment options an independent Certified Financial Planner like myself can review with you.
PROS of CDs
The first reason one might consider a CD is its security. FDIC (Federal Deposit Insurance Corporation) insurance up to $250,000 protects the investor in case the financial institution cannot meet its obligation and pay investors. As long as an investor has invested up to $250,000 inside their CD they would be made whole again in case the bank goes bankrupt. A second reason to invest in a CD is the fixed interest rate guaranteed by the bank to pay the investor. For those with excess cash sitting on the sidelines, CDs can be a better alternative than funds idle in your checking account. People are more inclined to spend money if they see it in their bank checking or savings accounts. The last advantage of a CD is if you incur an early withdrawal penalty for taking your money before the maturity date the amount of the penalty is viewed as tax deductible to the IRS. Please consult with your tax professional regarding this. Of course this last advantage should not be a reason to invest in a CD but is a way to minimize your losses.
CONS of CDs
Where to start? Let’s look at where CDs are sold. Banks and credit unions. The fact is these financial institutions are in the depository and lending business. These establishments are not in the business of manufacturing the best investment products. A bank’s competitive advantage is being able to market to the customers they already have. It is common practice for a walk-in customer to be pitched a CD or credit card as an add-on during your occasional bank visit. My point is why should an investor be limited to a small selection of bank products when they can leverage the time and expertise of an independent CFP to research all investment options in the open marketplace.
Now a more obvious disadvantage of CDS are the ultra-low interest rates they pay investors. Why lock up your money for five years to get a 2% interest rate? Investors have the ability to earn better rates of return on certain bonds. Another factor to consider with CDs is inflation risk. Things get more expensive every year in the U.S. Historically, America has seen 2-3% average inflation meaning if investment returns are not keeping up with this average you are essentially losing money. Accessibility is a concern with CDs because the bank will charge you an early withdrawal penalty if you take your money out before the maturity date. Usually this amount is six months of interest they deduct from you balance before distributing to you. Lastly, please think twice about investing in a CD with an IRA account. Individual Retirement Accounts are great tax deferral vehicles for retirement. Deferring 1-2% of interest gained may or may not help you get to your retirement goals or stay retired.
CD Investment Alternatives
- High interest savings accounts – Ally and Barclays Capital are some of the well-known online banks in the marketplace today. These institutions have very competitive interest rates compared to their CD counterparts. As of 2017 both savings accounts have interest rates at 1%. These accounts do not have any maturity dates meaning there are no early withdrawal penalties when taking your money out. To access your money, it typically takes 2-3 business days before funds are transferred to your main bank account of choice. Some online savings accounts may have a minimum initial investment, as of this post both Ally and Barclays Capital do not have a minimum. Similar to a CD any gains earned from the savings will be considered taxable income via tax form 1099. Lastly, these accounts have the same $250,000 FDIC insurance limit as a CD.
- Bonds – A qualified independent Certified Financial Planner has access to various corporate bonds investors can save money into. Bond interest rates range anywhere from 3-6% interest with maturities that vary from six months up to a few years. Interest earned is taxable income via tax form 1099 as a CD. An investor must consider the company stability and credit ratings of the bond issuer. Keep in mind bonds are not FDIC insured. A bond investor is giving up security for the potential for higher interest earned. In the event of a company bankruptcy, corporate bondholders are paid back their money before common and preferred stock holders. A sibling to corporate bonds are municipal bonds that pay tax free interest to the investor in the range of 2-4%. Muni bonds are a great vehicle for retirees looking to supplement their fixed sources of income like pensions and social security.
- Dividend paying investments – Stocks and alternative investments in real estate pay dividends to investors. Many household stocks in certain sectors pay consistent quarterly dividends of 3-4% to shareholders. Market risk is involved as the value of the stock can decrease at any point in time. Companies are not obligated to pay dividends to shareholders meaning companies can reduce or freeze their dividend at any time. More reason to research blue chip companies with a history of increasing dividends to aid one’s retirement income plan while maintaining full liquidity. Lastly, there are a handful of short term real estate investment trusts (REIT) that pay dividends of 4-5% to investors. These REITs are similar to a mutual fund in a 401k except the various holdings inside the REIT are multiple types of real estate properties instead of a basket of stocks and bonds. With an alternative investment in real estate there are income and net worth requirements along with sponsor and occupancy risk of the underlying real estate holdings.
Investing in a CD should be a careful decision. For ultra-conservative investors happy with lower rates in return for FDIC insurance, a CD may be right for you. For others that need more competitive interest rates we reviewed a few alternatives. The benefit of working with an independent Certified Financial Planner is the open architecture platform that gives investors access to a variety of investment options with the client’s best interest at the top. Other financial institutions may have a corporate agenda to strictly adhere to and be forced to sell their own company’s products to meet sales quotas. At the end of the day the choice is yours. If you would like a no-cost review of short term investment options for your situation you can call or email me to discuss more. I promise no sales pitch and an objective view for your specific situation.
Dustin Javier, CFP® AWMA®
CERTIFIED FINANCIAL PLANNER™
President | Dean Johnson Advisory, LLC