No matter how simple an investment or product sounds, there are always risks we must be aware of. The same thesis is true of a certificate of deposit (CD). Typically these products offer greater earnings potential compared to regular savings accounts, making them appear more desirable for the average consumer. But there are two risks that must be evaluated when considering these types of accounts.
While CDs are fully protected by FDIC deposit insurance when purchased from an insured bank, there are still risks associated with the product. With interest rates at historic lows, one of the largest perils is inflation. In 2011 the inflation rate was 3 percent and last year it was 1.7 percent. While we often view the impact of inflation on things we purchase at the grocery store, it always sneaks its way into our investments. Few 1-year CDs yield more than 1 percent, so if inflation comes in at 2 percent then consumers can actually be losing money in real terms, meaning after we account for inflation, when the CD matures!
A second risk associated with CDs is the interest rate set by the Federal Reserve, which largely dictate what CDs will yield. Changes in interest rates can have a large influence on a consumer’s income if a large percentage of their income is relied upon assets that are held in a certificate of deposit. One of our hardest hit demographics still reeling from the financial crisis are seniors trying to retire and live on a fixed budget. In 1980 a certificate of deposit (CD) yielded 14 percent, so $1 million in the bank produced $140,000 in annual income. Not bad. By 2000 the rate was 5 percent, and today the same 5-year CD would yield a whopping 1.5 percent according to recent data from Bankrate.com, reducing your income to $15,000 a year. Very few of us can survive an 80 percent reduction of income over a 33-year period of time. But that’s exactly what some families face if they narrow their investment options to simple bank products.