Certificates of Deposit: What to Consider and How to Use Them

My name is Brian Scribonia and on this episode of the Common Sense Financial Podcast. So the question is, does it make sense to lock in CD rates while rates are high? If you have money sitting in a bank account that you don't need and the CD rate is offering a higher rate than your savings, then I would consider it as an option. But here's the thing, if you think rates are going to continue to rise then you would want to stick with shorter maturity dates. But if you believe rates have topped out, then locking in a longer term CD could make more sense.

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There's a difference between what's real and what's true. You're listening to the Common Sense Financial Podcast. I'm your host Brian Scribonia. Thanks for tuning in and let's get into today's topic. In an economic climate marked by rising interest rates, there is a renewed interest in bank CDs. But with trust in banks dwindling and convoluted reserve requirements, the question does persist. Should you invest in CDs? And like most things, it depends on your needs and goals. But most of all, it's important to understand the product you're placing your money into before choosing to deposit money into a CD. And I understand that a bank CD may may seem as basic as the ABCs, but I find that many people have little knowledge or understanding about why banks issue them, how they're used, and how they're priced. This may not seem all that important, but the truth of the matter is it is and has a lot to do with building wealth. Because wealth isn't created by buying a CD based on a rate. It's created by understanding why the rate may not be all that important. I live just south of St. Louis, Missouri, and like many rural communities, there are banks and gas stations at every corner city seemingly right on top of each other. And as I drive around town, I see banks promoting the rates on digital boards, much like gas stations who post their price per gallon of fuel. When one bank increases the rates, it often seems like all the other banks follow suit and they raise their rates. But there is more to this than banks watching to see what the bank down the street does. Just to stay competitive, banks use what is known as the federal funds rate, also known as a benchmark rate. This is the rate banks charge one another to borrow money overnight that's needed to maintain reserve requirements. Further upstream in the decision making process is the Federal Open Market Committee, or fmoc, who meet throughout the year to discuss and set monetary policy. And within these policies, rates are set and are most likely linked to inflation. And when rates are set, banks may adjust rates on loans, deposits and certificates of deposit. But just like any business, banks will adjust rates to compete in their market as they seek to cover their costs and maintain a profit. They of course use rates to attract more customers, to help expand the number of depositors they have, which is a indicator of growth. And the added deposits, of course, helps to cover the loans they originate. I discuss more about how banks work in my podcast what to Know about How Banks Work, and I'll link to that podcast in the show notes. But CDs specifically are an attractive tool for banks because unlike a deposit a account, CDs actually lock up customers with a maturity date, which just gives banks better control of their cash flow. And we see customers drawn to the opportunity to capitalize on higher rates as they seek to maximize their returns. But when you look at the math, the rates really don't matter all that much. Okay, they matter some, but they don't matter as much as the difference between inflation rates and interest rates. And here's why. If inflation is running at, let's say, 7% and interest rates are, let's say 5%, the net of this, of course, is 2%. And if inflation is, let's say zero and rates are at 2%, the spread is still 2%. So it's easy to get enthusiastic about higher interest rates on deposits. But we can't take our eye off the ball. Inflation is the enemy. It is the headwind that erodes our purchasing power. And it's why we should pay attention to the net return after inflation. From a debt standpoint, the increase in rates is impacting lending. It is why I believe that rates are unlikely to remain elevated for long. When you consider the gridlock within the housing market and the amount of debt our government holds, it's hard to believe rates can remain elevated over the long term. The government is desperately trying to combat inflation by raising rates. They have a 2% inflation target and want to see unemployment higher, which doesn't make sense for the average person. But it is all about price stability. When there are more jobs available than unemployed workers, theoretically everybody could get a job and with that people spend money. But if the economy cools, business and theory would stop hiring and with higher unemployment, spending slows. But here's the deal. These higher rates not only impact consumers, but it also impacts the government. According to the Congressional budget office, or CBO, in June of 2023 they projected that annual net interest costs on the federal debt would total $663 billion in 2023 and almost double over the next decade. Interest payments would total around $71 trillion over the next 30 years, taking up to 35% of all federal revenue by 2053. These numbers are impacted by interest rates and with lower rates come lower interest payments. Regardless of our opinions, theories and preferences, we know that the economy runs in cycles and the cycle we are in will transition at some point. So the question is, does it make sense to lock in CD rates while rates are high? If you have money sitting in a bank account that you don't need and the CD rate is offering a higher rate than your savings, then I would consider it as an option. But here's the thing. If you think rates are going to continue to rise, then you would want to stick with shorter maturity dates. But if you believe rates have topped out, then locking in a longer term CD could make more sense. Now of course I don't have a crystal ball. If it were me, it would be advisable to look at money market rates and fixed annuities to compare rates across the board as these types of accounts often share similar rates rates. But they are all differences to understand before making a decision. Certificates of deposit are offered by banks as a savings account that offers a fixed interest rate over a specified period of time ranging from one month to up to five years. They carry penalties if funds are removed before maturity and they are FDIC insured up to $250,000. Fixed rate annuities are issued by insurance companies and are financial products that offer a fixed interest rate over a specified period of time. Early withdrawals can incur a penalty. Interest earnings are tax deferred until you start taking distributions and the guarantees are backed by the claims paying ability of the insurance company and are insured by what is known as the State Guarantee Association. Then you have money markets, which are funds issued by financial institutions that are backed by highly liquid short maturity investments, maturities that usually range from overnight to just under a year. Assets can be quickly converted to cash with minimal loss of value, generally considered more risky than a bank, CD or insurance company annuity. And the underlying investments include such things as treasury bills, commercial paper and CDs. And the rate does have some sensitivity as interest rates and monetary policies can change, so navigating the financial markets in general can prove to be a challenge, especially during times of uncertainty. But while CDs offer safety of fixed returns, they are not devoid of risks and limitations. It's essential to understand both the micro and macroeconomic factors that affect CD rates before diving in. And as always, a balanced portfolio features a mix of different products and strategies and can be the most prudent strategy in times like these. By working with professionals who are keeping an eye on economic indicators and who understand the implications of various government decisions, they can help you make informed decisions about where to place your money. To learn how to make informed decisions regarding which investments to choose, which options are appropriate for your situation, and where to look, you can access a multitude of resources on my website@Brian Scribonia.com that concludes today's show. I'm Brian Scribonia. Thank you for listening to the Common Sense Financial Podcast. Thanks for listening to today's show. If you liked what you heard, be sure to subscribe on YouTube and Spotify so that you can receive notifications when we release new episodes. I'm Brian Scribonia and this is the Common Sense Financial Podcast.

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