The Certificate of Deposit (CD)
Conservative savers often covet certificates of deposit (CDs) to earn returns on cash. Because of Federal Deposit Insurance Corporation (FDIC) guarantees, CDs are associated with safety. Beyond principal protection, however, certificates of deposit do introduce distinct risks for savers. Familiarize yourself with how banking certificates are structured, so that you may improve your total returns, while preserving safety.
Banks offer certificates of deposit to receive short-term financing. In exchange, depositors earn interest until maturity. Interest rates generally increase with extended durations. For example, you two-year CDs may pay three percent interest rates, while one-year CDs provide two percent rates. Because of their safety, CD total returns are relatively minimal. The risk-return tradeoff specifies that investors are willing to accept lower returns, for higher levels of safety.
FDIC coverage backs banking certificates of deposit. As of 2010, FDIC guarantees $250,000 worth of deposits per customer, per bank. The $250,000 guarantee is a temporary provision, and will be reduced back to $100,000 on January 1, 2014. Wealthy depositors increase their total protection by taking out multiple CDs at different banks. For example, ten $50,000 CDs at ten different banks would be fully insured, as opposed to one $500,000 CD. Half of the principal amount on the $500,000 CD would not be guaranteed.
The Federal Reserve Board
Federal Reserve Board monetary policy influences CD interest rates and safety. In recession, the Fed lowers interest rates. Lower interest rates reduce borrowing costs, and encourage businesses and private individuals to take out loans and invest money. Conversely, the Fed raises interest rates to slow down the economy and combat threats of inflation. Inflation refers to increasing price levels, and lost purchasing power for cash.
Inflation and Opportunity Cost Risks
Inflation, interest rate and opportunity cost risks jeopardize CD safety. These three risk factors are all related. Inflation erodes the purchasing power of your CD principal and interest payments. Further, the Federal Reserve is likely to increase interest rates, in response to inflation. At that point, interest-rate risk emerges, because newer CDs are paying higher rates than the certificates you may already own. Higher prevailing interest rate levels translate into lower valuations for existing CDs and fixed-rate investments.
Opportunity cost risk describes missed profit opportunities from competing investments. CDs are subject to opportunity cost risks, relative to stocks. Stock market investments are more likely to provide real returns, over the long-term. Real returns subtract inflation from calculated investment returns. For example, real returns on a five percent CD may only be 1 percent, if inflation runs at four percent during the time period. Retirees that have bought CDs for decades may have missed the opportunity to become stock market millionaires.
CD laddering and investment diversification preserve the safety of your financial portfolio. CD laddering calls for you to take out CDs at various maturity dates to manage interest rate risks. Shorter-term CDs can be quickly reinvested at higher rates, if interest rates rise. Meanwhile, longer-dated CDs lock in rates, if future interest rates fall. Meanwhile, diversified portfolios include stocks, alongside CDs to reduce inflation and opportunity cost risks.