Many people have savings that they would like to invest, but don’t know where to start. Due to recent scandals and huge losses in the markets, many have lost faith in stocks, bonds and real estate and are desperate to find a truly safe investment option. One of the most common investments of choice for people looking for a risk-free way to grow their savings is certificate of deposit accounts.
What is a CD account?
Certificate of deposit accounts are special accounts offered by banks and brokers, they are basically the opposite of a regular loan: the investor lends his money to the bank for a specified period of time during which the bank pays him interest for the use of the funds.
Many institutions offer fixed interest rates, but variable interest rates are also available. This type of account differs from bank savings accounts in that depositors cannot withdraw the money at any time; they have to wait for them to mature or pay a severe penalty.
Why are CD accounts considered safe?
Certificates of deposit are perceived as safe because they are insured through the FDIC. The FDIC is a federal insurance coverage provided by the government, instituted during the Great Depression, its goal was to provide peace of mind to consumers and protect them against bank runs. However, there is a limit to the volume of FDIC-insured funds per account.
Since the FDIC is backed by the United States Treasury, many people view CDs as the latest “Risk free” investment. As such, the rates of return tend to be very low, but are still a bit above savings account rates to compensate people today for their bank-tied income. Typically, certificates provided by smaller banks, which have large monetary needs, will offer a higher interest rate than large, cash-rich banks. Because of this, consumers can generally find much better rates of return on their investment at smaller banks.
Are CD accounts really risk free?
The reality is that there is no such thing as a risk-free investment. There are dangers associated with CD accounts that many buyers don’t take into account.
The first danger is the threat of inflation. Let’s say you lock up your savings in a 5-year CD with an interest rate of 2%, but during those five years, inflation skyrockets to 5%. Due to the high penalty for accessing your money before the term is up, your money is inaccessible and is essentially shrinking and losing value. On the other hand, for those who had access to their money through a standard savings account, they could simply withdraw the cash and invest it in something tangible, like assets or land, before it became worthless.
A more commonly overlooked threat, which may be closely related to inflation, would be the interest rate threat. If an investor deposits funds into a 5-year CD with a 2% rate of return, and the base interest rate increases to 4% in the days or weeks that follow, there is an opportunity cost of holding the money. A person with a regular savings account, on the other hand, will see the interest rate on it adjust as rates rise. Of course, in a savings account, the interest rate is usually lower to begin with.
Inflation and fluctuating interest rates are risks that increase with the term of your investment. The longer the time before maturity, the greater the possibility of changes in interest and inflation. Short-term CDs, on the other hand, have incredibly low risk because there may be fewer opportunity costs than the shorter time. Because of this, many investors choose options with shorter terms or options that allow them some control in the event of inflation or interest spikes.
In conclusion
CDs are an investment designed primarily for people who are looking for a higher interest rate than a savings account, but who don’t need the money for any length of time. Due to FDIC insurance, investors feel safer investing in them than in stocks and bonds or other more dangerous investments.
Certificate of Deposit accounts are a great way to grow a fund for college, savings for your children, or for your own retirement. The longer the term of the investment, the higher the interest rate, so as long as the funds are not needed for emergencies or other pressing matters, they are a relatively safe way to grow your savings.