Beware of the Dangers of CD Investing
BY JIM GERMER
Special to the Herald
My mother, God bless her, liked investing in certificate of deposits. Investing in CDs was popular for conservative investors like my Mom, during President Carter's 1970s economic debacle.
Banks usually offer CDs as investments paying a flat rate of interest for terms of six months, one year, two years, five years and sometimes longer. CDs are insured by the Federal Deposit Insurance Corp., that covers your original investment plus interest earned up to certain limits.
My millennial clients find it hard to believe that the six-month CD rate paid a whopping 17.98 percent interest rate, according to ForecastChart.com, in August 1981. CD rates of return were considered competitive with higher risk investments, such as stocks and bonds, in the 1970s and 1980s.
Retirees and people now living on fixed incomes are watching anxiously, and in horror, as their savings dwindle because of low CD interest rates. CD rates have, unfortunately, hovered at a low 1 percent interest rate since 2009.
Now inflation, taxes, and not generating enough retirement income make it unwise to invest in assets earmarked for long-term use. Reduce the dangers of not diversifying your portfolio. Consider:
Inflation and Taxes -- Traditionally inflation mirrors CD interest rates, and CD rates drop when inflation declines. Losing purchase power is a real, not an imaginary challenge when holding CDs long-term.
Consider what happens to a $10,000 CD earning 1 percent interest with 3 percent inflation in a 25 percent tax bracket. After five years, your CD has lost more than $1,200 in purchasing power.
If inflation is a big problem, taxes are even worse. You'll likely pay taxes on interest earned on CDs whether your interest is paid to you or is left compounding. Taxes are due every year and they are taxed at the CDs owner's tax rate. Sadly many people pay 25 percent income tax, or more, on the paltry CD interest they earn from banks.
Outside legal limits of FDIC Insurance -- Low CD rates indicate CDs as investments are most appropriate for short-term time horizons. Still the Federal Deposit Insurance Corp. offers principle and income protection to holders of bank CDs.
Take comfort in knowing that there's a $250,000 guarantee available for CD depositors if your bank fails. You can't exceed, applicable limits per bank, to ensure maximize FDIC maximum limits.
Individual account owners are insured up to $250,000. For example, if an account owner is single with a checking account and two CDs, he's safe if within the $250,000 limit. But if the total of those account were $400,000, $150,000 would be lost in a bank failure. Understand:
With revocable trust accounts, each owner is insured up to $250,000. This is for each unique, eligible beneficiary.
Your share of a joint account at a bank is also included in one $250,000 award.
All IRAS are added up for calculating a $250,000 limit.
Accounts may be opened at different banks as each separate bank insures up to the $250,000 limit.
Early Withdrawal Penalties -- Pulling CD funds prematurely may trigger a penalty. Normally, banks charge a penalty, forfeited interest, of at least 60 to 90 days on a one year CD. Depending on longer bank CD terms, forfeitures could range from six months -- to an entire year's interest. However, some banks offer penalty-free CDs.
Automatic Renewals -- Usually when a CD matures, a bank will send a renewal notice. Do nothing, and the bank rolls expired investment proceeds into another CD. This may be a big mistake because investment opportunities on CDs, and other investments, are constantly changing. A two-year CD, for instance, shouldn't always be replaced with another two-year CD. You may not obtain the best interest rate, both locally and nationally, by what's first offered by the bank, and your circumstances may have changed.
Don't be lazy. Buying CDs where you have your checking account can be a big mistake because your bank may offer inferior or low interest on their CDs. A one-year CD might be 1 percent at some banks and other bank CDs might be 1.26 percent.
Long-Term CDs and Call Features -- Not all CDs are the same. Banks with callable CDs can terminate your investment should CD interest rates drop. While callable CDs typically pay a higher interest rate than non-callable CDs, realize that you may not be able to keep them for their full term. If this happens, you might not find the same rate offered to reinvest your principle.
Brokered CDs, from brokerage firms, might not be insured by FDIC. While brokerage CDs might not have premature penalties, demand for brokerage CDs in the secondary market might be limited and you might not gain full investment value on sale. This is because some investors might not pay full price, if a competing certificate of deposit pays more interest.
Jim Germer is a Bradenton CPA and financial adviser at Cetera Financial Specialists, LLC, member FINRA/SIPC.