With today’s fledgling economy and jittery stock market, many conservative investors are looking for a safe place to invest their money. Earning a dollar is much more difficult today than it was just a few years ago. Therefore, saving a buck and earning a buck have become much more important. Certificates of Deposit (CDs) may be the solution for the conservative investor. Most people have heard the term CD by visiting their local bank, or through various forms of advertisement such as radio and television. However, what they don’t know is the basic definition of a CD.
A CD is formally defined as any debt instrument issued by a bank that usually pays interest. The components of a CD including the term over which interest is accumulated, the rate of interest, the annual percentage yield (APY) and the minimum deposit required.
Though CDs are most often purchased by the average person at a physical bank location, there are a few other ways to purchase them. Brokerage CDs have become increasingly popular over the past decade or so. Numerous online banking institutions offering CDs have popped up over recent years.
With the collapse of several banking institutions, many investors wonder, “Are CDs a good investment?” The answer lies mainly within the rates that are offered. Recently, a one-year CD could be bought through a brokerage firm at a rate of approximately 2%. Though making 2% is better than losing money in the stock market, money at this rate is still being lost. Losing money in short-term CD is closely related to the inflation rate. In February of this year, the inflation rate was 3.01%. This means that investing in a one year CD at 2% results in a net loss of 1.01%.
Like other investments, CDs are sensitive to the overall economic environment. However, for a CD to be truly a worthwhile investment, it must realize a profit above and beyond the rate of inflation. Longer-term CDs may achieve this end, but they may incur something known as interest rate risk. This means that over the term of CD, interest rates rose significantly, but the investor is relegated to the rate defined at the initial purchase. The initial purchase rate of the CD may become significantly lower than the current rate of interest over time, but this is the risk of a longer term CD when lower interest rates exist.
The collapse of a few of our country’s largest banking institutions elicited an environment of fear reminiscent of the days of the Great Depression. This fact led to questions regarding the safety of CDs as well as general savings accounts at banks. However, the FDIC stepped in at the appropriate time and assured the safety of depositors monies.
CDs can be a profitable investment, but good research and rate comparison are necessary. It is important that CDs are federally insured, because there are those that are not. Investors must be cautious of overseas firms offering CDs at higher than normal interest rates. The main idea to remember about CDs is that in order to be profitable, they must exceed the rate of inflation and the investor must understand interest rate risk.