With what looks like the first rate cut in years set to come this September, many investors are racing to lock in rates on CDs, some of which are yielding north of 5%.
While it's hard to argue with a (nearly) risk-free rate of return of that magnitude, investors ought to proceed with caution when hunting for high-yielding CDs.
In this video, I'm going to discuss the pros and cons of CDs in this current rate environment, explore alternative options for your cash and ultimately determine if CDs are really worth your time and money. So stick around, and let's get into it.
Welcome back to another video from One-Up Financial. I am your host Eric Presogna, CPA and Certified Finanical Planner here to help you maximize your income, reduce taxes and invest smarter.
Today we're going to be discussing CDs given the recent hype around yield-chasing I've noticed in the financial media as of late.
I remember only a few years ago when water cooler talk focused on speculative tech stocks and building homes in the metaverse.
Today, it seems Bored Apes have been replaced with HYSAs, MMAs and CDs!
Cash has always been king, but now it appears to be cool.
5% yields with little to no risk of loss...what's not to love?
CDs in particular seem to be in the spotlight now as the Fed gears up to cut rates and investors hurry to lock in those juicy yields.
What is a CD?
A Certificate of Deposit (CD) is a type of savings account offered by banks and credit unions. It allows you to deposit money for a predetermined period at a fixed interest rate. In exchange for locking up your funds until the CD matures, you generally receive a higher interest rate compared to a traditional savings account.
Pros of CDs
Guaranteed Returns: CDs offer a guaranteed return on your investment. Unlike stocks or mutual funds, where returns can fluctuate, the interest rate on a CD is fixed and secure.
Safety: CDs are considered a low-risk investment. Almost all CDs are insured by the Federal Deposit Insurance Corporation (FDIC) in the U.S. up to the applicable limits, making them a safe option for your savings. (Quick Note: CDs are not all FDIC-Insured: CDs offered through Credit Unions are insured by the National Credit Union Share Insurance Fund.)
Potentially Higher Interest Rates: Generally, CDs offer competitive interest rates relative to standard savings accounts.
Cons of CDs
Lack of Liquidity: Unlike a savings account, you cannot access your funds without penalty until the CD matures. This lack of liquidity can be a drawback if you need immediate access to your money.
Early Withdrawal Penalties: One of the main drawbacks of CDs is that withdrawing your money before the term ends typically incurs a penalty. This could mean losing some of the interest earned, or in some cases, a portion of your principal.
Inflation Risk: If inflation rates rise, the fixed interest rate of your CD might not keep pace with the increasing cost of living. This means your purchasing power could be eroded over time.
Reinvestment Risk: This is the risk that the proceeds received when a CD matures may be reinvested at a lower interest rate than the initial investment. Essentially, it’s the risk that the returns on your reinvested funds will be lower than the returns you were initially receiving.
CDs aren't the only game in town, however. There are other cash alternatives with hefty yields may want to consider.
Alternatives to CDs
(1) Money market accounts (MMAs)
A money market account (MMA) is a type of savings account that typically offers higher interest rates compared to traditional savings accounts, while still providing liquidity and safety for your funds. Here are some key features:
Interest Rates: MMAs usually offer slightly better interest rates than traditional savings accounts.
Liquidity: While MMAs offer higher interest rates, they limit the number of monthly transactions allowed and may reduce your interest rate if you exceed your allotted transactions.
Minimum Balance: Many MMAs require a higher minimum balance to open the account and to earn the highest interest rates. Some accounts may charge fees if the balance falls below this minimum.
Safety: MMAs are often insured by the Federal Deposit Insurance Corporation (FDIC) up to the standard insurance amount.
Features: Depending on the institution, some MMAs can come with check-writing privileges or debit cards, making these accounts a slightly more liquid option than high yield savings accounts.
(2) High Yield Savings Accounts (HYSAs)
A High-Yield Savings Account (HYSA) is a type of savings account offered by online banks, credit unions, and some traditional banks that shares similar characteristics to MMAs such as:
Interest Rates: The primary benefit is the higher Annual Percentage Yield (APY) compared to standard savings accounts. Online banks tend to offer higher yields than their brick and mortar counterparts.
Safety: Like MMAs, HYSAs are usually insured by the FDIC or, if offered by a credit union, the NCUA.
Liquidity: Similar to MMAs, you're limited on the number of withdrawals or transfers you can make each month, and generally don't have check writing or debit card capabilities.
No or Low Fees: Many HYSAs come with no monthly maintenance fees, but it’s essential to check for any conditions, such as minimum balance requirements or withdrawal limits.
Online Accessibility: Many HYSAs are offered by online banks, which often allow for easy management of your account via mobile apps or online platforms.
(3) T-Bills
T-bills are short-term debt securities issued by the U.S. Department of the Treasury to help finance the government's borrowing needs.
These investments are different from both MMAs and HYSAs in that they're not issued by banks and have to be purchased through an intermediary like a brokerage firm or the U.S. Treasury itself (treasurydirect.gov). Some other features include:
Short-Term Maturity: T-bills have very short maturity periods, typically ranging from a few days to one year. The most common maturities are 4 weeks, 8 weeks, 13 weeks, 26 weeks, and 52 weeks.
Discounted Purchase Price: T-bills are sold at a discount to their face value. For example, you might purchase a $1,000 T-bill for $980. When the T-bill matures, you receive the full face value of $1,000, with the $20 difference representing your interest earned.
No Regular Interest Payments: Unlike other bonds, T-bills do not pay periodic interest. Instead, the interest is the difference between the purchase price and the face value you receive at maturity.
Safety: Though these securities aren't insured like MMAs and HYSAs, they are backed by the full faith and credit of the U.S. government and considered to be one of the safest investments in the marketplace.
Liquidity: T-bills can be easily bought and sold in the secondary market if you need to access your funds before the maturity date.
Tax Considerations: The interest earned on T-bills is exempt from state and local income taxes, though it is subject to federal income tax.
Are CDs Really Worth it?
In my opinion, if you're going to tie up your money for 6 months, 9 months or a year, you better be getting compensated for that illiquidity. In other words, the yields on CDs need to be meaningfully higher than MMAs, HYSAs and T-Bills.
Let's take a look at the numbers as of August 22nd, 2024:
(Note that savings account figures were derived from bankrate.com, CD rates from investopedia.com, and T-Bill yields taken from treasury.gov)
Top CD yield - 5.4% (5-month term offered by a credit union in Indiana that requires a $5 donation to be a member)
Top MMA yield - 5.3%
Top HYSA yield - 5.3%
3-Month T-Bill - 5.28%
Unless you're looking to move $10 million or more into a conservative cash alternative, the additional 10 basis points (.1%) in yield you'd get on the CD compared to the other options isn't, in my opinion, worth signing up for a random credit union in Indiana and locking your money up for 5 months (note that the other high yielding CD rates were at or less than the highest yielding MMAs and HYSAs).
Granted, if and when rates fall, so too will yields on MMAs and HYSAs which would make CDs more enticing if you're looking to lock in high rates. But remember, CDs are taxed at the Federal and State level whereas treasuries are exempt from state tax. So if you're in a high taxed state like California or New York and paying, for example, 8% in state taxes, you'd need to find a CD paying more than 5.7% to match an equivalent T-Bill yielding 5.28%.
Closing
In short, I find it hard to make the case for investing in traditional bank CDs given there are better alternatives in the marketplace. That is, at this moment in time.
What are you doing with your cash? Are CDs part of your investment strategy? Please leave me a comment below or shoot me an email, I'd love to hear from you.
Thanks as always for watching our videos. If you're interested in staying up to date with our market and financial commentary, please subscribe to our blog at oneupfinancial.com/blog.
Thanks again, and we'll see ya in the next one!
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