Certificates of deposit (CDs) have been paying interest rates of 2% or less for a number of years. But you might be surprised to learn that they haven’t always yielded so little. In the early 1980s, some CDs paid up to 18%. Of course, inflation was also much higher back then. So does it make sense to buy CDs in an environment of rising inflation? Here’s what you need to know about CDs and some possible alternatives.
The central theses
- Investing in CDs may not make sense in an environment of rising inflation as you could invest your money at an interest rate that is too low.
- There are some types of CDs and other relatively low-risk investment products that adjust for inflation, although they also have their downsides.
- If you’re looking to get out of a badly paid CD, it might be best to wait until it’s due rather than pay early withdrawal penalties.
How rising inflation affects CDs
Unfortunately, CDs are not the ideal investment in an inflationary environment. If the interest rate on a CD cannot keep up with inflation, your money loses purchasing power. This applies in particular to CDs with longer running times. While they pay slightly higher interest rates than short-term CDs, they also tie up your money longer and expose it to a higher risk of inflation. If you wish to withdraw your money before the CD term expires, you will typically face prepayment penalties that can cost you all the interest your CD has earned and even some of your principal.
“The real returns on some of the best CDs I could find are still around -6% annually,” said Nate Hoskin, CFP, financial advisor at Hoskin Capital, a wealth management planning service. “Yes, it’s better than having cash on hand, but there are far better options.”
For example, most high yield savings accounts (HYSAs) pay about as much as a CD, excluding prepayment penalties. They also enjoy one of the greatest benefits of CDs: insurance coverage through the Federal Deposit Insurance Corporation (FDIC) or the National Credit Union Administration (NCUA).
Depending on how much risk you are willing to take, there are other alternatives as well.
Some alternatives to standard CDs
While standard CDs pay a fixed interest rate for a set period of time, there are several types of CDs that adjust their interest rate as inflation warms (or cools). These certificates are sold under different names: inflation-linked CDs, inflation-protected CDs, inflation-indexed CDs, inflation-protected certificates of deposit (CDIPs), floating-rate CDs, and bump-up CDs.
These products can offer you some inflation protection, but they also have their drawbacks. One is that your initial interest rate may be lower than the interest rate available on a traditional CD at the time. Another reason is that your rate could fall if inflation recedes – a particular hazard if you’re buying your CD just as inflation is at its peak.
The most widely recommended alternative to CDs are Series I US savings bonds, commonly known as I-Bonds. An I-Bond carries about the same liquidity risk as a CD (you can’t cash it out until you’ve had it for 12 months). And while it’s not FDIC or NCUA insured, it essentially has no default risk because it’s government-backed.
The upside is that I-Bonds adjust their rates for inflation every six months. As of April 29, 2022, they are currently earning an interest rate of 7.12%. “It’s a far better alternative,” says Hoskin. In addition, the interest is tax-free at the state and local level.
I-Bonds accrue interest for 30 years if you don’t redeem them sooner. There is no penalty for redemption after five years. You can buy an I-Bond for as little as $25 or as much as $10,000.
Other relatively low-risk alternatives to CDs are Treasury Inflation-Protected Securities (TIPS). Like I-Bonds, TIPS are tied to changes in the consumer price index, specifically the CPI-U. (You pay a fixed interest rate, but your capital increases as inflation rises.) TIPS are available for $100 and up in $100 increments and in five, 10, or 30-year terms. Like I-Bonds, they are exempt from state and local taxes.
Floating rate notes are yet another option. These are government or corporate bonds with interest rates that “vary” as the index to which they are linked rises or falls. You can buy them through a brokerage firm or in the form of a variable rate mutual fund or exchange traded fund.
Get out of your CDs
If you’re tied to one or more fixed income CDs that are losing ground to inflation, you have several options, none of which are ideal.
- You can just wait for the CD to expire, take the money and reinvest it in something else. (Make sure you give instructions to your bank or credit union when the time comes, or they can just convert the money to a new CD and lock you up again.)
- You can withdraw your money early and pay a prepayment penalty. These penalties can be relatively hefty, so even if you put the money into a better-paying investment right away, you may not come out on top.
- If you bought a brokered CD from a brokerage firm or independent sales agent, you can get rid of it by selling it on the secondary market. However, the low interest rate makes your CD less valuable compared to newer, better-paying CDs, and you may have to sell it at a loss.
Where do you buy I-Bonds?
The primary way to buy I Bonds is online at TreasuryDirect.gov. You can also purchase them with your tax refund when filing your federal income taxes for the year.
What is the CPI-U?
The CPI-U is one of two consumer price indices used by the Bureau of Labor Statistics (BLS) to track inflation. It stands for CPI for All Urban Consumers and, according to the BLS, covers around 93% of the total population. The other CPI is Wage earners and clerks (CPI-W). The CPI-U is generally what the government or others refer to when citing the CPI.
What is a Bump Up CD?
A bump-up CD is a CD that allows you to request an increase in your interest rate (a “bump-up”) one or more times during the life of the CD when interest rates generally rise. If interest rates fall, you can stay at your current interest rate.
The final result
While a high inflation environment is generally never a great thing, inflation poses a particular threat to fixed income investments like certificates of deposit. If you’re looking for a place to invest in times of inflation, there are a number of alternatives to choose from some as safe as CDs, others a little more risky.