CD Rates May Not Be Worth a Long Commitment Until Bank Rates Rise

All bank rates--CD rates, money market account rates, savings account rates, etc.--have been in the same boat over the past year. Those bank rates fell sharply with the recession, and just when it seemed they couldn't get any lower, they fell some more. This has caused bank depositors to make some tough choices, and the degree of difficulty is magnified when it comes to choosing CDs.

By nature, interest rates on CDs differ from money market rates and savings account rates because of the added complication of considering the length of the commitment. Choosing a savings or money market account involves shopping around to find the best product under current conditions. Choosing a CD, on the other hand, involves not only assessing current conditions, but also essentially making a forecast about the future. After all, you need to do the right thing not just according to today's conditions, but according to what you expect will transpire over the course of the CD term.

This article will review some of the issues involved in committing your money to a CD, both in general and under today's conditions.

Committing to CD Rates and Terms: A Double-Edged Sword

Although a certificate of deposit demands a decision about the terms of your commitment, that commitment is not inherently a bad thing. In fact, you don't have to look very far into the past to see an example of when that commitment might have been a huge benefit.

In 2006, CD rates climbed to a multi-year high and stayed near that level for most of 2007. Anyone who committed to a 4- or 5-year CD in that period would now be earning interest several percentage points above today's interest rates. So, if you can lock in something good, commitment is just fine.

Of course, the flip side is locking into CD rates only to see market rates rise before the end of your term. The problem with this can be worse than just a missed opportunity for making more money. Rates will often rise because inflation is rising. If this happens after you've made a long-term CD commitment, you may find that you are not only missing out on higher interest yield, but you are also losing ground to inflation.

Choosing CD Rates in a Low Rate Environment

The difficulty in choosing CD term lengths is heightened under today's conditions on the heels of the Great Recession. There are three factors that should make you reluctant to commit to a long-term CD these days:

• CD rates recently reached an all-time low. That doesn't mean they couldn't fall further, but if historical norms are a guide, rates will more likely rise than fall from here.
• The economy is at a turning point. Changes in the economy often trigger changes in bank rates, and a strengthening economy would likely mean higher CD rates. But, while there have been recent indicators of economic recovery, the overall picture is still mixed. With such uncertainty about when sustained economic growth will return, it's a poor time to lock into a long-term CD.
• Inflation is making a comeback. After a rare period of deflation, inflation has returned. Until CD rates adjust upward to keep up, locking into a long-term CD could mean losing purchasing power.

Under these circumstances, unless you have a special purpose for locking a pool of money at today's CD rates, you would do well to keep your CD terms short and nimble. Fear of commitment is not always a bad thing.

 

Source:

US Bureau of Labor Statistics • Economic News Release: Consumer Price Index Summary • http://www.bls.gov/news.release/cpi.nr0.htm

Showing 0 comments | Add your comment