For many years, certificates of deposit (CDs), have paid interest rates of 2% and less. You might be surprised that they haven’t always paid so little. Some CDs paid as high as 18% in the 1980s.Naturally, inflation was much higher back then. In an environment of rising inflation, does it make sense for CDs to be bought? Here’s what you need to know and some options.
These are the Key Takeaways
- In a rising inflation environment, CDs might not be a good investment because you could be locking your money at a too low rate.
- There are a few CDs and other investments products with low risk that adjust for inflation. But they have their limitations.
- You may be better off waiting for your CD to mature than to pay early withdrawal penalties if you want to get rid of a low-paying CD.
How rising inflation affects CDs
CDs are not the right investment for an inflationary climate. Your money loses purchasing power if the CD’s interest rate isn’t in line with inflation. This is especially true for CDs that have longer terms. These CDs pay higher rates than short term CDs, but they also lock your money for a longer duration, making them more vulnerable to inflation. You will typically be subject to early withdrawal penalties if you want your money out before the CD’s term expires. This can result in losing all of the interest earned on your CD and possibly even your principal.
According to him, “The real yield on some CDs that I found were the best is still around -6% per year.” Nate Hoskin CFP, is a financial adviser with Hoskin Capital. This wealth management planning service provides wealth management planning services.. “Yes, it is better than keeping cash in your pocket, but there are better options.”
HYSAs, which are high-yield savings accounts, pay approximately the same as a CD and have no early withdrawal penalties. They also have the added benefit of insurance coverage from the Federal Deposit Insurance Corporation, National Credit Union Administration (NCUA) and other credit union administrations.
There are other options, depending on how high you are willing to take risks.
Alternatives to Standard CDs
Standard CDs pay a fixed, set interest rate for a period of time. However there are several CDs that will adjust their rate as inflation rises or falls. These certificates are available under a variety names, including inflation-linked CDs (inflation-protected CDs), inflation-indexed CDs (CDIPs), certificates of deposit inflation protected (CDIPs), variable rate CDs and bump-up CDs.
These products can provide some inflation protection but also have their drawbacks. Your initial interest rate could be lower than that on a traditional CD. Another danger is that your rate could drop if inflation drops. This is especially true for CDs purchased at the peak of inflation.
The most recommended alternative to CDs, is Series I U.S. Savings Bonds, also known as I Bonds. An I bond has the same liquidity risk of a CD, but you can’t cash it out until it’s been in your possession for 12 months. It is not FDIC- or NCUA insured, but it is backed and guaranteed by the government.
The upside to I bonds is that they adjust their interest rates every six month in line with inflation. As of April. As of Apr.Hoskin says, “This is a much better alternative.” Plus, interest is exempt from tax at both the state and local levels.
If you cash in your bonds sooner, I bonds will earn interest for a period of 30 years. Cashing in an I bond after five years is free of penalty. An I bond can be purchased for as low as $25 or as high as $10,000.
TIPS, Treasury Inflation Protected Securities, and CDs are also low-risk alternatives. TIPS, like I bonds, are tied to changes of the Consumer Price Index (specifically the CPI-U). TIPS pay a fixed interest rate but your principal will rise as inflation rises. TIPS are available at $100 and higher, in $100 increments, with terms of 5, 10, or 30 year terms. TIPS are exempted from all state and local taxes, similar to I-bonds.
Another possibility is floating-rate bonds. These are corporate or government bonds with rates that “float” depending on the index they’re tied to. They can be purchased through a brokerage company or as a floating rate mutual or exchange traded fund.
How to get the most out of your CDs
You have a few options if you are locked into fixed-rate CDs that are losing ground due to inflation.
- You can wait for the CD to expire, then take the money and reinvest it. You can wait for the CD to expire, take the money, and then reinvest it in another investment.
- You can withdraw your money early and pay a penalty. These penalties can be very high, so even if your money is immediately invested in a better-paying business, you may not be able make it back.
- You can sell a broker-dealer CD on the secondary market if you have one. Your CD’s low interest rate may make it less valuable than other CDs with better rates of return, so you might have to sell it at loss.
Where can you buy I Bonds?
TreasuryDirect.gov is your primary source for I bonds. You can also purchase them using your federal income tax refund.
What is the CPI – U?
CPI-U is one of the two consumer price indexes used by the Bureau of Labor Statistics (BLS), to track inflation. It stands for CPI-U, which is the Consumer Price Index for All Urban Consumers. According to the BLS it covers approximately 93% of the population. Wage Earners and Clerical Workers is the other CPI (CPI-W). The CPI -U is what the government and others refer to when they cite CPI.
What is a Bump-Up CD and How Does It Work?
A bump-up CD allows you to request an increase in interest rate (a “bump-up”) at any time during the CD’s term. This is if rates are generally rising. If rates are falling you can continue with your current rate.
The Bottom Line
High inflationary environments are not good for anyone. However, inflation can be a problem for fixed-rate investments like certificates or deposit. There are many options available if you’re looking for an investment option in times of inflation. Some are just as safe and others are a little more risky.
