Is a Certificate of Deposit Right for You?

Certificates of deposit (CDs) are popular banking products with conservative savers seeking to earn returns on cash. CDs, of course, are notable for safety of principle, from the backing of FDIC insurance coverage. Still, certificates of deposit, like all financial moves do introduce distinct risks. Inflation and opportunity cost risks are especially concerning. 

Certificates of Deposit

Financial institutions offer certificates of deposit to customers in exchange for short-term financing. Depositors then earn interest until maturity when principal is repaid in full. 

Expect CD interest rates to increase with extended durations and higher opening balances. Now, CD rates may range from all but nil for one month to 5% if you agree to lock up cash for at least one year. Banks do levy financial penalties for early CD withdrawals. 

FDIC Insurance Coverage

In 2008, the Federal Government increased FDIC insurance coverage limits from $100,000 to $250,000 per customer, per bank, in response to the Great Recession housing bust and credit crisis. 

Wealthy depositors increase total FDIC protection by taking out multiple CDs at different banks. For example, ten $50,000 CDs at ten different banks would be fully insured, as opposed to one $500,000 CD. Half of the $500,000 single CD principal would be uninsured.  

The Federal Reserve Board

The 1913 Federal Reserve Act tasked the Board with the contradictory dual mandate of both maximum employment and a stable price level. In recession, we expect the Federal Reserve to lower interest rates, which encourages the market to borrow, spend, and invest to stimulate the economy. Amid recovery and a strong economy, The Fed will drive rates higher, to curb economic growth and stifle inflation. 

In recent times, the federal funds rate has been driven aggressively higher to 5.5% to combat rampant, post-pandemic inflation. Expect CD rates to closely parallel this market benchmark.

Inflation and Interest Rate Risks

Interconnected inflationary, interest rate and opportunity cost risks all jeopardize CD safety. First, inflation silently destroys your CD principal and interest purchasing power. In response, the Federal Reserve Board is likely to raise interest rates, which diminishes valuations for existing fixed-rate securities. New CDs would then pay out more interest than the certificates that you may already own. 

CDs are especially susceptible to opportunity cost risks, relative to the real returns on stocks. Over the long-term, we expect cash management products to simply keep pace with inflation, which effectively translates into a real return of zero.

The most productive investments will represent shares of stock in businesses with pricing power to raise prices faster than the rate of inflation. Savers who patiently held CDs for decades may have easily retired early, as millionaires, had they have plowed that same cash into the likes of Apple, Microsoft, or Visa stock.    

Cash Management Strategy

CD laddering combined with portfolio diversification will allow for both safety of principal and growth potential. A proper CD laddering strategy will have you take out CDs at various maturity dates to build out a cash reserve and save for medium-term goals.  

Through CD laddering, shorter-term CDs can be quickly reinvested at higher rates, if interest rates were to rise. At the same time, longer-dated CDs will lock in rates, if future rates were to fall. 

A properly diversified portfolio, of course, would include cash management products, stocks, and bonds. Expect equity investments to perform exceptionally well through economic expansion. The Standard and Poor’s 500 Index averages 11% annual returns, as a stock market benchmark.