- A CD is a stable-value savings account that offers a guaranteed rate of interest in exchange for a commitment to leave your money on deposit for a specified term.
- Prior to 2022, CD rates were modest. Since then, the Federal Reserve has aggressively hiked the federal funds rate to a range of 5.00% to 5.25%. The most competitive CD rates are comparable to this range.
- CDs make sense for conservative investors that value guaranteed income, have adequate liquidity and are minimally concerned with long-range inflation risk. They don’t make sense for investors with erratic liquidity needs and long investing horizons.
- Popular CD alternatives include fixed annuities, U.S. Treasury bills and high-yield savings accounts.
How Rates Have Changed
The primary determining factor of a certificate of deposit (CD) rate is the federal funds rate, which is the overnight lending rate for banks and the foundation for all longer-term loans. The U.S. Federal Reserve utilizes this benchmark rate to influence domestic monetary conditions, as well as achieve its objectives of maintaining price stability and minimizing unemployment.
The Federal Reserve increases the federal funds rate to curb inflation, and it decreases it to stimulate the economy. Ever since the beginning of 2022, the Federal Reserve has been in rate hike mode, aggressively working to combat the highest Consumer Price Index (CPI) readings observed in over 40 years.
As a result, the federal funds rate has quickly shot up from a target range of about 0.00% to 0.25% in 2020, to a target range of 5.00% to 5.25% in 2023.
The most competitive CD rates have moved in conjunction with the federal funds rate – with a multitude of CDs in the six-month to 18-month space currently offering 5.00% or more. This has been a huge benefit for conservative investors long-yearning for decent yield ever since the Great Financial Recession.
CDs offering over 5.00% are only issued by the most competitive banks and credit unions. The national average CD rates for the highest-yielding terms are much lower, hovering around 1.50%.
Looking Ahead on CD Rates
While the Federal Reserve began to pull back on the federal funds rate hikes in late 2022, it still employs a restrictive monetary stance. It raised the federal funds rate by about 0.25% three times in 2023 and could act again – depending on whether inflation continues to moderate.
If the rate of inflation remains flat or declines, I expect the Federal Reserve to pause its rate-hiking campaign. However, if the rate of inflation increases, we are likely to see another 0.25% rate hike or two prior to the end of the year. If this happens, the most competitive CD rates could approach 6.00%.
Are CDs Recession-Proof?
CDs are one of the lowest-risk options available to investors. A myriad of banks and credit unions offer these stable-value time deposits to their customers with varying maturity terms and conditions. If structured properly, a CD is fully insured up to $250,000 for an individual account and $500,000 for a joint account. The Federal Deposit Insurance Corporation insures CDs issued by banks, and the National Credit Union Administration insures CDs issued by credit unions.
That said, CDs are not immune to economic downturns, especially those characterized by stagflation – soaring inflation, high unemployment and flagging productivity. We are not currently in such an environment, but persistent inflationary pressure has caused heightened anxiety around the prospect.
Pros and Cons of Buying CDs
Determining whether you should buy a CD is largely dependent on your investment objectives and tolerance for risk. Before you invest, make sure you have a sound understanding of the most prominent benefits and disadvantages of CDs.
- Very safe investments with zero credit risk below insured limits
- Stable-value instruments with zero volatility
- Competitive short-term interest rates
- Illiquid investments subject to early withdrawal penalties
- Interest rates earned can fail to keep pace with inflation, therefore eroding purchasing power
- Accrual basis taxation on earned interest does not align with cash flows
When Does a CD Make Sense?
Investing in a CD makes sense if you have adequate liquidity and want to put your money in a very low-risk instrument offering a guaranteed rate of interest. It makes even more sense if you have a relatively short investing horizon and anticipate moderate inflation.
In the current economic environment, shorter-term CDs are more attractive than longer-term CDs. The highest-yielding instruments have terms between six months and 18 months. Anything shorter or longer exposes you to uncompensated risk.
Market Risk Mitigation
A CD is a stable-value investment that offers a guaranteed rate of interest. The absence of volatility can be very beneficial to investors, especially for those who hold volatile assets, such as stocks and commodities. A CD can stabilize your portfolio during periods of instability and uncertainty.
Storing Your Savings Safely
As previously noted, CDs are insured by either the Federal Deposit Insurance Corporation or the National Credit Union Administration (up to specified limits). This government-sponsored protection eliminates credit risk and enables conservative individuals to invest confidently.
When a CD Doesn’t Make Sense
Investing in a CD does not make sense if you have erratic liquidity needs that could lead to an early withdrawal of your funds. If you also have a relatively long investment horizon and are sensitive to inflation, a CD is even less sensible. Consider some more context on these factors.
- CDs are inherently illiquid
- They require you to lock up your money for a specified amount of time. Early withdrawals are subject to a penalty that usually equates to a certain number of months of interest income. In some rare cases, a loss of principal is possible.
- Longer-term CDs are exposed to inflation risk.
- This is the possibility of experiencing a rise in the prices of goods and services that overshadows the fixed-rate income generated by your CD. Over time, this can significantly diminish purchasing power.
- CDs are taxed on an accrual basis.
- Generally, when you invest in a CD, your initial deposit and all interest earned is not accessible until maturity. However, as your CD accrues interest, it is taxable. For some investors, this can introduce significant cash flow complications.
Alternatives To Consider
CDs are a safe way to generate some passive income. However, there are a handful of attractive alternatives that exhibit low-risk and stable-value profiles. Consider these three options:
- Fixed Annuities
- Fixed annuities are low-risk insurance contracts that provide you a guaranteed stream of income in exchange for an upfront cash payment. The contracts can be customized with a variety of add-on features, which are referred to as riders. Learn more about annuity rates compared to CD rates.
- U.S. Treasury Bills
- U.S. Treasury bills are short-term debt instruments issued by the U.S. Department of the Treasury and backed by the full faith and credit of the federal government. Their terms span from one month to one year. Today, the most attractive tenures are three months, four months and six months. Each of these terms has a yield just under 5.50%.
- High-Yield Savings Accounts
- High-yield savings accounts are liquid savings accounts offered by online banking institutions. The absence of brick-and-mortar overhead allows these institutions to offer yields that far exceed traditional savings accounts and rival the best CD rates in the market. However, unlike CDs, the interest rates on these accounts can change at any time.
Alternatives to CDs
The interest rate environment and the investment landscape are constantly changing, which means it’s important to keep a watchful eye. If you need help assessing your options, consider consulting with a fiduciary financial advisor.
Editor Malori Malone contributed to this article.