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Why the 10-Year CD May Be the Worst Bank Product Ever

bad investmentsRemember the days when you could easily earn 15% APY on your savings? No? Well, if you were born after 1975, you probably don’t. These days, depositors get excited if they can earn anything over one percent without having to risk their money in the stock market, which is why long-term CD rates have become a popular alternative to savings accounts — the longer the deposit period, the higher the CD rate. Unfortunately, this chase for the high interest rates of yesteryear is leading people to lose money.

3 Reasons Why 10-Year CDs Are Bad Investments

One of the best 10-year CD rates I found is at Discover Bank — they’re currently offering 1.90% APY. As the bank points out on their site, this is much higher than the national average for similar CD products.

Now let’s say you’re impressed by this interest rate and decide to deposit $10,000 in Discover’s 10-year CD with annually-compounding interest. At the end of those 10 years, your balance would be $12,070.96. A profit of $70.96 might look decent, especially to a timid investor who would rather take a smaller return in order to avoid any type of market risk.

10-year cd

However, when it comes to CD accounts, it’s possible to have too much of a good thing. A return of under 2% APY may be competitive today, but 10 years from now, who knows? It could be horrible. The problem is that in order to get that interest rate now, you have to lock your money into a 10-year commitment, during which the interest rate remains fixed and you’re unable to access the money without paying a hefty penalty.

Plus, due to inflation, you will actually earn a lot less than $70 — in truth, you’ll lose money on the investment.

1. Inflation Eats Up Interest

Inflation is the gradual increase in the cost of goods and services over time. When Grandpa reminisces about how he could buy a bottle of Coke in 1932 for 13 cents, he’s describing the effect inflation has on on modern prices.

Inflation also affects the value of your money — the higher the rate of inflation, the less buying power your cash has down the road. For instance, a two percent annual inflation rate means an item that costs $1 today would cost $1.02 a year from now, essentially making the dollar you have today worth two cents less in that year.
long-term investments

So taking our hypothetical 10-year CD from above, a 1.90% return with this decade’s average inflation rate of 1.83% factored in would equal a true return of significantly less. And if the average rate of inflation over the next decade surpasses the return on your 10-year CD, you will actually have less money when the CD matures than when you first opened the account.

2. Long-Term CD Rates Prevent You from Jumping on Rate Increases

One of the positive characteristics of certificates of deposit is that they allow you to lock-in your interest rate, so that if deposit rates drop after you open your account, you hold onto your interest rate through the end of the term while everyone else has to settle for less. This positive, however, becomes a big negative when interest rates are already low — and rates have been lower than ever thanks to the Fed’s quantitative easing measures.

As Roben Farzad writes for Bloomberg Businessweek, “With the Federal Reserve at zero interest rates for nearly four years and further tamping down any and all bumps on the yield curve, savers have gotten killed for trying to do the right thing.”

Lock in long-term CD rates with extremely low rate now and you’re stuck earning a sub-par return should interest rates increase in the future. And if you decide to bail on the account early to take advantage of rising rates, you will have to pay an early withdrawal fee that will wipe out any interest earnings, and quite possibly some of your principal deposit as well.

The Fed has stated they’ll continue to keep the target rate between 0 and .25% through 2015, so depositing in a one- or two-year CD – even a five-year CD — isn’t too big of a gamble right now. Sealing your fate for an entire decade, on the other hand, especially when the additional gain a matter of tenths of a percent and the total return can’t even outpace inflation, is simply a bad move.

3. Less Than Two Percent Over 10 Years Is a Bad Return, Period

Regardless of the rate of inflation or the Fed’s plans, earning 2% or less on a 10-year investment is pretty sad. You don’t have to become a high-strung day trader to obtain double-digit returns. Simply investing in an S&P 500 index fund, for example, like the Vanguard 500 Index (VFINX), would be a much wiser long-term investment decision.

Like any market security, the S&P has taken some pretty big hits in the past, but the point of investing is not to make lots of money over a short period of time. Yes, there is risk involved in stock market investing, but you have to get over that fear if you really want to grow your money.

But heck, there are plenty of fully-liquid savings accounts offering higher interest rates than 10-year CDs.

Where you ultimately place your money should be a decision based on your goals –  if you want to preserve your savings in an FDIC-insured account, maintain some liquidity and earn enough interest to at least reduce the effects of inflation, a savings account or short-term CD is a good option. However, if you’re looking to maximize your return over a decade or longer, stay away from low-yield deposit products that rob you of potential earnings and speak with a professional about moderate-risk market investments instead.

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  • http://profiles.google.com/jumbocd Chris Duncan

    First, yes there is interest rate risk if rates go up, but there isn’t principal risk. When investing in the stock market, your principal is at risk. Depending on your horizon for the need of the funds, a large drop may not be able to be made up.

    Second, if you are smart about which 10-year CDs you are buying, you can gain a slight hedge by using long-term CDs that don’t have excessive early withdrawal penalties. Yes, there is the risk of a bank not allowing you to close the CD early or even changing the penalty, but that risk is quite small.

    Third, you need to compare apples-to-apples. You can’t average the inflation over the last 10-years and use that to demonstrate why a 2.45% over the next 10-years is bad. In 2007, you could have had a 10-year CD for near 6.00%. Currently that would look pretty good.

    You don’t know the future. Do the best with what today has for you. Sometimes that is a 10-year CD.

    • valsvet

      I agree with you 100%. The author, while making a remark about the stock market risk, should not in my opinion even compare CDs to equities. FDIC insured CDs are the best tools for capital preservation and income stream. I am 63, planning to work full time till 68. I just bought $200k worth of 10 year CDs at Fidelity yielding 3.30%. I also refinanced (in Feb 2013) my $120k mortgage at 2.75% (10 year). The rest of the money is in equities, junk bonds, short and med term bonds and 5% in gold and energy, $500k all together including CDs. Here is the way I see it: in 10 years I will have $266,000 guaranteed + whatever the rest of my money makes or loses + whatever I manage to save while still working (401-k). Should work for me.

    • gman

      I agree 100%…back in 08 when everything flew apart and I had a 7% CD with Capital One I wish I had my whole portfolio in Cap One CDs…My avg would be about the same or better with the CDs plus I would have gotten a lot more sleep.

    • gman

      Also would like to comment that all this diversification talk is confusing…it seems to me you should either stay all in cash and bonds or all in stocks as if you put 50% in each when one goes up the other goes down…negating the returns anyway.

  • Joe Fox

    What about money market? Is that preferable to a CD or a savings account?

    • Bea Marino

      I don’t know of any money market account that is going to give you 2%. The good thing about the MM is that you won’t have an early withdrawal penalty. I think MMs are good for storing money you might need for emergencies etc. In these terrible interest rate times, I would not want to have to go any lower than 2% for a CD and hopefully not as long out as 10 years. These are really bad days for savers who need to be risk-free.

  • timmy

    I just bought a 10 year CD that pays 3.3 percent for 10 years. With this investment, I’ll earn about $6700 on my $20000 investment over the next 10 years vs. zero in cash. Listen, I’m 54 years old and I will tell you that the last 10 years went by pretty fast and I think that I will really enjoy that $6700 when I’m 64. Of course, I will hopefully also make money on the dividend paying stocks that I own, but this comes without risk. You seem to be assuming that rates are on the rise. If you look at the history of rates and inflation, you will see that they move slow. I’ll take the 3.3% FDIC insured.

  • atl9pdnp

    all fine and dandy – nice math… but if you were invested in a 10 yr CD in 2000 or 2009 vs having your money in the stock market – you would have made money and preserved principle vs losing your shirt and praying that the market would return… and yes it did over a period of several years. If you are older, the advice in this article is very bad. If you are in your 20′s or 30′s and don’t have to worry about paying or your kids college or getting laid off then go for it… btw never put all your eggs in one basket – a mix is best in any situation.