Interest rates are rising, dividend paying stocks now feel like the Texas Giant for the first time in years (which, for those non-Texans, is a very big roller coaster), and gold prices are just as big of a ride as stocks. So it’s really no wonder that CDs are starting to gain attraction. Can you believe that the average six-month CD was at an all-time low in 2013 at 0.24 percent? Well, now we have officially seen the first six-month CD back over a full one percent. And even better, a five-year CD was just spotted at over 2.75 percent! So does this mean CDs are officially considered a good place for your money?
People often associate CDs with the feeling of safety. After all, the principle is guaranteed to be returned to you by the government. But would you consider an investment that loses money safe? Of course you wouldn’t, though more times than not, CDs do just that—lose money.
How? In the financial world there is something we learn called “after-tax real rate of return.” Simply put, this means the return minus the cost of living adjustment for that year (inflation) minus the taxes you pay on the return you made. For example, let’s take a look at a six-month CD that pays you one percent and assume that you are in one of the lowest tax brackets for 2018: 12%. The equation would look like this:
Return-Inflation for 6 months – Taxes = After-Tax Real Rate of Return or…
1.00-1.075-0.12= (0.195)
Now let us put some real numbers behind this. Assume this is a one hundred thousand dollar CD:
$1,000-$1,075-$120= ($195)
That is right. If you invested one hundred thousand dollars in a six-month CD today under the current inflation rate and with a twelve percent tax bracket, you would lose one hundred ninety five dollars over six months. If you do this twice this year under the same circumstances, you would lose double this amount—$390.00.
And this is the inflation rate the government is telling us that we are experiencing. We tend to think it is double this amount just by the everyday experiences we are all having ourselves with current prices. Furthermore, this doesn’t come close to allowing for dramatically rising healthcare costs.
CDs were instituted in the early 1960s and since that time, the story has remained the same: Rarely do CDs produce a positive after-tax real rate of return. But what about long-term CDs?
The Fed raises interest rates fairly often to combat inflation, which is often created by economic expansion. So my question to you is: do you think the economy is growing? Do you think it will continue to grow in over the near-term? If you answered “yes”, you will probably agree that we could face higher inflation. This means that even long-term CDs could suffer negative returns. In fact, looking back over the economic expansions periods since CDs began reveals that, most of the time, inflation was higher than the CD rate itself in the ensuing years.
What, then, is safe? Frankly, everything has risk—even cash and CDs run the risk of going broke safely. Interest rates are rising, and this is great news for our economy and great news for investors. There is no such thing as safe, but there is such a thing as being prudent with your hard-earned dollars. This means having an income plan, knowing where and what dollars you will or could need over the next three to five years, balancing the protection of these dollars with inflation and taxes in mind, and keeping the rest of your money invested in a t-ball approach to make sure you take care of you, your spouse and your family now and for always.
Don’t let your emotions manage your money. Remember to buy fear and sell greed as Warren Buffet says. Jumping out of volatility and into a “safe” CD right now is quite the opposite. Even if you can’t sleep at night and can’t stand the volatility of the market, you have options that can fight inflation, and at the very least, use these.