Certificates of Deposit (CDs) are an effective way of maximizing your savings, known for their predictable earnings and stability. By investing in CDs, savers tend to avoid the risks associated with other market-based assets, such as bonds and stocks. But in the long term, certificates of deposits may face a unique challenge that may pose serious risks – inflation.
Is CD a good investment option at times of inflation? Does it really impact the value of your investment in the long term? Let’s understand here.
The Federal Reserve Continues to Hike Its Federal Funds Rate
Since early 2022, the Federal Reserve has been increasing its federal funds rate, i.e., the rate at which banks lend and borrow money to one another. From March 2022, there have been rate increases almost 11 times, currently standing between 5.25% to 5.50% – the highest in over 20 years. The rate hike is the effect of the Fed’s initiative to curb inflation.
The federal funds rate does not directly lower or raise rates on your certificates of deposit. But the effect can be indirect. Typically, banks follow the same pace at which the Fed lowers or increases its funds rate. It is a determining factor for the rates on their savings accounts and loans, including certificates of deposit. Hence, a higher Fed rate may indicate higher CD rates – however, it may not happen immediately or it is not guaranteed.
In the face of inflation and rising Fed rates, CDs are witnessing the most competitive rates. Savers who have invested in CDs with 3-month to 5-year terms are now enjoying more than 4% annual percentage yields. Short-term CDs with 6 to 18-month terms are standing at a rate above 5%. Continuous increases in Fed rates have skyrocketed CD rates – from less than 1% in January 2022 to their recent heights of over 5% in 2023. The best banks and credit unions can offer you the highest rates.
Rising rates of CDs might make it a lucrative option to maximize your savings, especially when the rates of traditional savings accounts are near 0%.
Is it Worth Investing in a CD During Inflation?
According to many experts, investing in certificates of deposit may not be ideal in a rising inflation market condition. This is because your money will lose its purchasing power if the interest rate on your CD cannot keep up with the inflation rate. This is particularly true for certificates of deposit that have longer-term periods. Your money will remain locked up in a CD and you may miss out on using it on higher interest-paying investments.
Additionally, if you make an early withdrawal of your CD before the maturity date, it will result in penalties. On the other hand, one of the interesting aspects of CD is it comes with a fixed rate of return over the term period. This means you precisely know the interest amount you will earn during maturity – irrespective of the market conditions. At the time of inflation, the interest rate on your savings account may change. But the rate of interest earned on your already-purchased CD remains the same.
And if you are planning to invest in CD during inflation, it can be a smart option because interest rates tend to be higher when Fed fund rates are higher. With CD interests standing at a record high in 2023, this may be the right time to open a CD account and lock in a fantastic rate that can help maximize your savings despite the market conditions.
How to Mitigate the Impact of Inflation on CDs and Grow Your Savings?
When it comes to maximizing your savings, mitigating risks, and protecting your capital in the long run, investing in CDs may be the best option. Discussed here are some strategies that can help reduce the impact of inflation if you plan to invest in certificates of deposit:
- Check CD rates regularly and shop for the best deal: When inflation rises, the rates of interest on CDs are likely to rise. What you were eyeing as an excellent CD rate may no longer remain good next year. Therefore, it is crucial to check the rates regularly and shop around to grab the best deal at the right time.
- Invest in CDs with a shorter term: During inflation, it is ideal to opt for CDs that come with a shorter term. This will enable you to leverage potentially higher rates of interest. As mentioned earlier, CDs with a term period between 6 and 18 months are enjoying the highest APY of over 5%. Additionally, investing in shorter-term CDs would mean that your money will not remain locked up for a long duration. You can continuously assess the market conditions and adjust the investment strategy likewise.
- Consider Treasury Inflation-Protected Securities: TIPS are bonds issued by the government to safeguard your savings against inflation. It comes with a fixed rate of interest, but the principal amount will be modified based on the Consumer Price Index.
- CD Laddering: Usually, for CDs, higher interest rates come with longer terms. But this may not be ideal if inflation rises. In such cases, you may consider CD laddering. It allows you to open multiple CD accounts with varying term periods. This enables you to quickly withdraw funds at maturity and reinvest the amount to invest in CDs that offer higher interest rates.
- Inflation-indexed CDs: Some banks and financial institutions may provide options to invest in inflation-indexed CDs or bump-up CDs. These types of CDs provide a certain amount of protection against rising inflation because the interest rates will fall or rise at pace with market conditions. Bump-up CDs give you the option to request an increase in the rate of interest, though, the discretion lies with the bank.
The Bottom line
Certificates of deposit are a fantastic way to grow your savings and reduce investment risks in the near future. Even if inflation rises, CD rates may increase and ensure you a promising return – provided you shop around diligently and keep an eye on changing interest rates. In addition to CDs, you may also consider other savings strategies such as bank bonuses or high savings account rates.