Certificates of Deposit, A Scam?
How these financial products can be harmful but also very helpful
So you want to put your money somewhere for safe keeping but don’t want to invest in stocks as the potential risk is too great. You have heard of these things called Certificates of Deposit that are marketed as a 100% safe place to hold your money and let it grow over time. While these products have good uses there may be those who want… A little more.
What’s A CD Anyway?
Before we get ahead of ourselves let’s take a step back and learn more about what a Certificate of Deposit actually is and who might invest in them.
The idea is surprisingly simple. You give the bank an amount of money and say you won’t touch it, let’s say $10,000. In exchange, the bank gives you a higher-than-normal interest rate. Depending on how long you agree to not touch your money the rates can differ. Given the national average interest rate for savings accounts is 0.13% currently, it may seem appealing.
Right now if you give the bank $10,000 dollars and say you won’t touch it for 1 year you will get, on average, a 0.65% interest rate. At the end of 1 year, you would be $65 richer. This really isn’t a lot but above all else, it is the safest way to store your money. CDs really are the only place in finance where the risk is virtually 0. Even if the bank is unable the pay you back the government would step in through the FDIC and make sure you get your money
The problem is when you give your hard-earned $10,000 to the bank in exchange for 0.65% interest the bank is turning right around and lending it out. A good example would be a $10,000 car loan for 1-year at a 3.44% interest rate. While you collect $65 dollars a year the bank is collecting $279 of your money.
This may seem like the bank is fleecing you but Certificates of Deposits are a great way to save money. And one of the ways these products are good at helping people save money is through fees.
When you buy a CD the bank will often say you can’t take your money out early without paying a fee. Generally, this is the equivalent of 6 months of interest payments. This little “catch” is what makes CDs a great tool to save money.
Let’s say you want to buy a house in a year you could take your down payment and with 0 risks give it to the bank at a higher interest rate. This is a win-win for everyone. It ensures you don’t spend the money, the bank gets some sweet sweet liquidity and you get a higher-than-average return on your money.
That’s why I think CDs are a great way for people to store money in the short term. For any term longer than 1-2 years CDs become drastically less useful. That’s why there is an alternative for those with a longer time horizon.
Higher Returns
Let’s say you have a longer time horizon and would like to earn a higher yield than what a CD may offer. Well you are in luck because I have 2 such categories to tell you about.
The Wonderful World of Bonds
Bonds may seem like a confusing mess of a world, and in some respects it is, but it is the second safest way to earn a higher yield on your money.
The safest and most popular bonds are Government bonds. These pieces of paper are secured by the US government and offer an interest rate that is usually higher than those found at most banks.
The big thing to pay attention to is interest rates. Unfortunately, interest rates are a finicky thing and are decided by the Federal Reserve. You may have heard talks of raising and potentially even lowering rates. The rate in question is called the Fed Funds rate and has a big impact on the yield you might get from government bonds. As of writing the interest yield on a 2-year bond is 3.5% which is more than 5x that of the average CD.
Unfortunately, this rate is ever-changing (as demonstrated by the graph). So there are better times to take advantage of these rates than others. Right now the Fed Funds rate is quite high for a variety of reasons but generally, the trend is lower interest rates over time.
If you are interested in buying government bonds the easiest way is through a broker like Charles Schwab and Fidelity. Of course, you could always go to TreasuryDirect and buy them there but that may not be the best idea.
The Wonderful World of Dividends
To move away from the risk-less options to the risky-er options we have dividend-paying stocks. When a company gets bigger and has more established cash flow they may choose to pay a dividend. This is cash paid to owners of stock. Pepsi is a very popular stock that pays 2.66% of its $173 stock price to investors every year. Typically dividends offer a higher yield than CDs and even bonds.
While I wouldn’t recommend buying individual dividend-paying stocks you could get exposure through an ETF like SCHD. While dividends are an option the subject veers off into investing in general so if you want to learn more you can check out this video here.
Getting a higher yield through dividends requires a deeper dive into investing and all the unique challenges that come with the space. I won’t go any further in-depth here but I would encourage everyone to start to learn more about the space if you haven’t before. Over the last few years, I have built a Youtube channel exploring all the inner workings of a lot of the investing world. If you want a little more here is another video explaining more of my thought process.
So What Now?
We covered quite a bit here so you may be wondering what now? Well, now it’s time for you to figure out what is best for you. If you just want a quick place to put some money and get a higher interest rate than just a savings account a CD might be best.
If your time horizon is a little longer you may want to consider taking advantage of Government bonds and the higher-than-average yield there.
And if you are willing to learn a little more and take a little more risk there is a whole world of dividend-paying stocks to consider.
All of this may seem fairly confusing at first but I promise it gets easier as you learn more. There are a lot of terms and styles, approaches, and products offered. It’s a long journey, especially for those that we’re never taught as kids. But I hope I could shed some light on this area and you leave a little smarter than before you read.