With the Federal Reserve raising its benchmark interest rate month after month, rates on lending products have climbed as well. Certificates of deposit (CDs) are no different. The average rate on a six-month CD has ticked back up to just below 1%, significantly above the lows of 0.14% in recent years.
With all that going on, financial advisors might ask, is the certificate of deposit back? Whether you’re looking for short-term savings or a long-term place to invest, is this a product worth recommending?
To answer that question, SmartAsset spoke with Yale Kofman, deputy chief investment officer with BMO Wealth Management’s Family Office. Read on for his answer.
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CDs Are Not Enough to Combat Inflation
Kofman says he understands why someone would to want to put their money in CDs. Rising interest rates have certainly drawn attention back to the certificate of deposit and other banking products. “But they’re forgetting that they’re still losing to inflation,” he says.
The problem with a certificate of deposit is twofold, he says. First, there is the absolute return. An average 12-month certificate of deposit pays 1.49% interest. Yet year-over-year inflation is currently around 5.5%. For an investor, this means that they will lock their money up for 12 months while it loses four points’ worth of value.
This isn’t just a low return, it’s a money-losing position.
CDs and Opportunity Costs
The second, bigger issue Kofman cites is opportunity cost. Investors who want a stable, safe asset can almost always get a better return with Treasury debt or corporate bonds. That’s particularly true once you factor in taxes and inflation.
Kofman says he calls out taxes because “our perspective is always after inflation, after tax, after fees, what’s what you take home?”
For example, consider someone buying a short-term product to hold their cash. They might buy a six-month CD or a six-month Treasury bill. The Treasury bill yields 4.8%, already far higher than the 0.97% that an average six-month CD will offer. But given the special tax status of Treasury debt, the effective return on the Treasury asset would be even higher. For an investor making around $75,000, they would need to find a CD paying 5.32% to generate the same after-tax return as a short-term Treasury bill paying 4.8%.
“From a tax-equivalent perspective, just even owning a T-Bill is going to be better for them than being in a CD,” he says.
The Case for CDs
Unless someone has a lot of money to invest, the difference in absolute return between a good certificate of deposit and a bond will often be relatively small. This is particularly true for short-term assets. Someone who even invests $50,000 will likely see little yield over a six- or even 12-month period in terms of money gained. That’s true regardless of which product they buy.
In this case, investors may sometimes want assets that they have a greater comfort level with. And this is the one area where CDs do have an advantage over bonds and Treasury debt.
“There’s kind of an ease-of-use concept here,” Kofman says. “Let’s say that you have an account with your bank, and it’s in a checking account, but you don’t need that much. So, OK, what are you going to do with your excess cash? And you’re being prudent … maybe you look at a CD.”
Yes, an investor will get a better return with a Treasury bill or an I bond, but investors need to understand what these products are. They need to understand the after-tax and after-inflation advantages of debt products, and they need to know how to buy assets like a Treasury bond or corporate debt.
“You gotta go through the hoops of doing that,” Kofman says. “Some people find that a little bit daunting.”
By contrast, an investor can simply ask their existing bank about certificates of deposit. There is significant convenience and comfort level with that transaction. Retail investors are likely to understand this product in a way that they don’t fully understand the bond market. They also may not be familiar with navigating Treasury.gov or a brokerage site at all.
With interest rates rising, certificates of deposit now offer better yields than they have in several years. But they will still lag behind other competing investment products investors can choose.
If your client wants a better yield, a certificate of deposit will almost always underperform. If your client prioritizes familiarity, however, a certificate of deposit can provide that.
Tips for Growing Your Financial Advisory Business
- Let us be your organic growth partner. If you are looking to grow your financial advisory business, check out SmartAsset’s SmartAdvisor platform. We match certified financial advisors with right-fit clients across the U.S.
- Expand your radius. SmartAsset’s recent survey shows that many advisors expect to continue meeting with clients remotely following COVID-19. Consider broadening your search. And work with investors who are more comfortable with holding virtual meetings or spacing out in-person meetings.
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