In saving money, safety has always had an opportunity cost; that is, lower rates of return than for instruments incurring greater risk. Today, this is perhaps truer than ever at a time when so many are fleeting to safety. So, how can we offer ourselves the greatest opportunity while we are obsessed more with the return OF our money than the return ON it?
Regardless of the trend of recent decades toward greater sophistication in retirement savings, the certificate of deposit, or CD, is still king. The obvious advantage of the CD over traditional savings accounts is that they typically yield significantly higher interest; with the primary drawback being the commitment that one incurs to maintain the deposit for a specified period, usually from six months to five years. The longer the term of the CD, the higher the associated interest rate.
So, how do we maximize growth in CDs while maintaining access to funds we need? One common method is “laddering,” that is, purchasing multiple overlapping CDs with maturity dates spread out so that funds are made regularly available without having to suffer the lower rates associated with shorter terms. Today, however, we have the added concern that interest rates are so low that the added interest of a longer term is possibly not worth the risk of having the money obligated when rates go up.
Shopping for CDs is a balancing act; weighing the available rates against the obligation of the time deposit. To add complexity to the decision, penalties for early withdrawals vary significantly between banks. The penalty for withdrawing early from one bank may be quite stiff, while another bank may only penalize the account a small portion of the interest earned, often as little as one month’s interest. Especially today, comparing penalties is a critical part of CD shopping.
So, what are the alternatives to the certificate of deposit? In an effort to retain old depositors and woo new ones, banks are occasionally offering high yield savings or money market accounts with interest rates comparable to CDs, but with complete liquidity. It is wise to keeps one’s eyes open for offers like this, but one must be wary of limitations and fine print.
Finally, there is the old reliable fixed annuity, offering usually higher interest than CDs, tax deferral, and sometimes greater liquidity. While fixed annuities have traditionally had greater surrender penalties and poorer liquidity than CDs, to remain competitive, more recent products have been known to offer immediate withdrawal of principal at any time without penalty. If a more suitable alternative is found early on, one can just pull out the funds and start over.
It is important not to lose sight of the power of tax deferral. As of this writing, rates for many annuities were hovering around 2.75%. Because of the effects of tax deferral, a taxable CD would have to earn around 3.7% on average to keep pace, while 5-year CD rates are currently averaging 2.26%, per BankRate.com. Where appropriate, annuities can be laddered as well (provided of course that the annuitant has not established a guaranteed income stream).
In this season of challenging savings interest rates, it pays to compare carefully, including more than just interest rates in this comparison. As always, it is wise to involve a qualified financial planner or advisor in this decision; and bear in mind that the term “qualified financial advisor” typically does not describe anyone employed within your local bank branch.
My name is Rob Drury, and I am the executive director of the Association of Christian Financial Advisors, headquartered in San Antonio, TX. The ACFA is the nation’s largest nonprofit financial planning network.