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The Promise of Safety With CDs

By manybanking.com Staff
Instability in the market and massive losses in stock portfolios has caused a recent wave of fear about equity investments. In such an environment, so-called safe investments have gained in popularity. Chief among the so-called safe investments are certificates of deposit (CDs).

CDs are time deposits, which provide a guaranteed return based on a fixed interest rate. When a CD’s term expires, the investor’s principal plus interest earned may be withdrawn.

These banking products are considered safe in part because the Federal Deposit Insurance Corporation (FDIC) provides limited insurance coverage on these funds should the holding bank fail. The current level of coverage is $250,000 per depositor, per type of account (individual or joint). Because of the banking crisis, this limit was temporarily raised from $100,000 in 2008 and is scheduled to return to the original limit on January 1, 2010.

Another reason CDs are considered safe is because there is a guaranteed return of the principal plus interest when the CD matures. With equity investments, there is no such guarantee of principal preservation, and huge losses of principal are possible, as the market has recently shown. Because the principal is not at risk with certificates of deposit, these investments do not carry high interest rates. Investors trade the security of knowing that they will not lose money for the loss of potentially higher returns in riskier investment vehicles.

One of the main risks to investing in CDs, however, comes from inflation. In times when inflation is high and interest rates are not, CD holders may find they have lost money when adjusted for inflation. The money invested in a certificate of deposit may earn interest, but those interest earnings may not outpace the loss in purchasing power from inflation. For example, if an investor bought a 12-month CD with an interest rate of 1.47%, upon reaching maturity, the investor would earn around $147 in interest for a total of $10,147. If, however, inflation were greater than 1.47% in that year, that $10,147 would not have the same purchasing power as the original $10,000 investment.

Predicting future inflation is difficult because there are so many variables to consider. Recent market interventions by the Federal Reserve, including lowering interest rates and printing more money, have caused fear of inflation in many. At the moment, however, deflation seems to be a more pressing concern thanks to the lending crisis and overall economic slowdown.

For investors looking for a safe place to park their cash without fears of losing the principal (disregarding inflation), certificates of deposit are an appropriate choice. The rates earned on CDs are typically higher than traditional savings accounts, interest-bearing checking accounts and money markets. However, with today’s low interest rates, the safety of CDs may come at the expense of some purchasing power when the CD finally matures.

—For more ways to save, spend, invest and borrow, visit MainStreet.com.

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