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Remember the days when you could easily earn 15% APY on your savings? No? Well, if you were born after 1975, you probably don’t.These days, depositors get excited if they can earn anything over one per cent without having to risk their money in the stock market, which is why long-term certificates of deposit have become a popular alternative to savings accounts — the longer the deposit period, the higher the CD rate.
Unfortunately, this chase for the high interest rates of yesteryear is leading people to lose money.
3 Reasons Why 10-Year CDs Are Bad Investments
One of the best 10-year CD rates I found is at Discover Bank — they’re currently offering 2.10% APY. As the bank points out on their site, this is much high than the national average for similar CD products.
Now let’s say you’re impressed by this interest rate and decide to deposit $10,000 in Discover’s 10-year CD with annually-compounding interest. At the end of those 10 years, your balance would be $12,310. A profit of $2,310 looks pretty great, especially to a timid investor who would rather take a smaller return in order to avoid any type of market risk.
However, when it comes to CD accounts, it’s possible to have too much of a good thing. A return of 2% APY may be amazing today, but 10 years from now, who knows? It could be horrible. The problem is that in order to get that interest rate now, you have to lock your money into a 10-year commitment, during which the interest rate remains fixed and you’re unable to access the money without paying a hefty penalty.
Plus, due to inflation, you will actually earn a lot less than $2,310 — maybe even lose money on the investment.
Inflation Eats Up Interest
Inflation is the gradual increase in the cost of goods and services over time. When Grandpa reminisces about how he could buy a bottle of Coke in 1932 for 13 cents, he’s describing the effect inflation has on on modern prices.
Inflation also affects the value of your money — the higher the rate of inflation, the less buying power your cash has down the road. For instance, a two per cent annual inflation rate means an item that costs $1 today would cost $1.02 a year from now, essentially making the dollar you have today worth two cents less in that year.
So taking our hypothetical 10-year CD from above, a 2.10% return with this decade’s average inflation rate of 1.83% factored in would equal a true return of significantly less. And if the average rate of inflation over the next decade surpasses the return on your 10-year CD, you will actually have less money when the CD matures than when you first opened the account.
10-Year CDs Prevent You from Jumping on Rate Increases
One of the positive characteristics of certificates of deposit is that they allow you to lock-in your interest rate, so that if deposit rates drop after you open your account, you hold onto your interest rate through the end of the term while everyone else has to settle for less. This positive, however, becomes a big negative when interest rates are already low — and rates have been lower than ever thanks to the Fed’s quantitative easing measures.
As Roben Farzad writes for Bloomberg Businessweek, “With the Federal Reserve at zero interest rates for nearly four years and further tamping down any and all bumps on the yield curve, savers have gotten killed for trying to do the right thing.”
Lock in an extremely low rate now and you’re stuck earning a sub-par return should interest rates increase in the future. And if you decide to bail on the account early to take advantage of rising rates, you will have to pay an early withdrawal fee that will wipe out any interest earnings, and quite possibly some of your principal deposit as well.
The Fed has stated they’ll continue to keep the target rate between 0 and .25% through 2015, so depositing in a one- or two-year CD – even a five-year CD — isn’t too big of a gamble right now. Sealing your fate for an entire decade, on the other hand, especially when the additional gain a matter of tenths of a per cent and the total return can’t even outpace inflation, is simply a bad move.
Two per cent Over 10 Years Is a Bad Return, Period
Regardless of the rate of inflation or the Fed’s plans, earning 2% or less on a 10-year investment is pretty sad. You don’t have to become a high-strung day trader to obtain double-digit returns. Simply investing in an S&P 500 index fund, for example, like the Vanguard 500 Index (VFINX), would be a much wiser long-term investment decision.
Like any market security, the S&P has taken some pretty big hits in the past, but the point of investing is not to make lots of money over a short period of time. Yes, there is risk involved in stock market investing, but you have to get over that fear if you really want to grow your money.
Where you ultimately place your money should be a decision based on your goals – if you want to preserve your savings in an FDIC-insured account, maintain some liquidity and earn enough interest to at least reduce the effects of inflation, a savings account or short-term CD is a good option. However, if you’re looking to maximise your return over a decade or longer, stay away from low-yield deposit products that rob you of potential earnings and speak with a professional about moderate-risk market investments instead.