Bank CD Safety
Conservative savers buy certificates of deposit, or CDs, to earn returns on cash. Because of guarantees by the Federal Deposit Insurance Corporation, or FDIC, guarantees, CDs are associated with safety. However, beyond principal protection, certificates of deposit do introduce distinct risks for savers. Familiarize yourself with how banking certificates are structured, so that you can improve your total returns while preserving safety.
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Identification
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Banks offer certificates of deposit to receive short-term financing. In exchange, depositors earn interest until maturity. Interest rates generally increase with extended durations. For example, two-year CDs might pay 3 percent interest rates while one-year CDs provide 2 percent rates.
Because of their safety, CD total returns are relatively minimal. The risk-return trade-off specifies that investors are willing to accept lower returns for higher levels of safety.
Features
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The FDIC coverage backs banking certificates of deposit. As of 2010, FDIC guarantees $250,000 worth of deposits per customer, per bank. The $250,000 guarantee is a temporary provision, and will be reduced back to $100,000 on January 1, 2014.
Wealthy depositors increase their total protection by taking out multiple CDs at different banks. For example, 10 $50,000 CDs at 10 banks would be fully insured, as opposed to one $500,000 CD. Half of the principal amount on the $500,000 CD would not be guaranteed.
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Considerations
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Federal Reserve Board monetary policy influences CD interest rates and safety. In a recession, the Fed lowers interest rates. Lower interest rates reduce borrowing costs, encouraging businesses and private individuals to take out loans and invest money. Conversely, the Fed raises interest rates to slow down the economy and combat threats of inflation. Inflation refers to increasing price levels and to lost purchasing power for cash.
Warning
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Inflation, interest rate and opportunity cost risks jeopardize CD safety. These three risk factors are all related. Inflation erodes the purchasing power of your CD principal and interest payments. Further, the Federal Reserve is likely to increase interest rates, in response to inflation. At that point interest-rate risk emerges, because newer CDs would pay higher rates than the certificates you might already own. Higher prevailing interest rate levels translate into lower valuations for existing CDs and fixed-rate investments.
Opportunity cost risk describes missed profit opportunities from competing investments. CDs are subject to opportunity cost risks relative to stocks. Stock market investments are more likely to provide real returns over the long term. Real returns subtract inflation from calculated investment returns. For example, real returns on a 5 percent CD may only be 1 percent if inflation runs at 4 percent during the time period. Retirees who have bought CDs for decades might have missed the opportunity to become stock market millionaires.
Strategy
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CD laddering and investment diversification preserve the safety of your financial portfolio. CD laddering calls for you to take out CDs at various maturity dates to manage interest rate risks. Shorter-term CDs can be quickly reinvested at higher rates if interest rates rise. Meanwhile, longer-dated CDs lock in rates in case future interest rates fall.
Diversified portfolios include stocks alongside CDs to reduce inflation and opportunity cost risks.
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References
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