What inflation is doing to your CD rates

Is your CD at risk? The answer may surprise you.

You may think the risks to your certificates of deposit are few and easily managed:

  • There is an early withdrawal risk with CDs, but you can easily avoid that by not taking money out of your CD before its maturity date.

  • There is the remote chance a bank could fail; but with FDIC limits for CDs at $250,000 per depositor at each institution, most people fall well within this coverage.

Inflation, an invisible threat

How else can a CD lose value? Well, it may be happening to you right now. After lying dormant for years, inflation is suddenly a force to be reckoned with -- and it could make the money you get out of a CD worth less than what you put into it. At the very least, inflation is eating into the return you are earning on your CDs. But things are getting worse.

How inflation affects your CD

The years 2012 through 2015 marked a period of extraordinarily low inflation. For those four calendar years, annual inflation was 1.76 percent, 1.51 percent, 0.66 percent and then 0.66 percent again in 2015. So, while CD rates were low, at least you had a fighting chance of beating inflation if you concentrated on long-term CDs and shopped for the highest rates.

Then things changed a bit. Inflation was slightly over 2 percent in 2016 and 2017. You could still beat inflation in CDs, but only if you found one of the very best rates.

Inflation gained 0.5 percent in January of this year alone. While inflation over the past 12 months is still right around the 2 percent mark, virtually all of that inflation occurred over the past six months. Inflation is picking up the pace.

Here's why you can't afford to take that sitting down. At the current average 5-year CD rate of 0.91 percent, a $10,000 investment would be worth $10,463.36 in five years. However, at a 2 percent annual inflation rate, that would have the purchasing power of just $9,476.98 in today's dollars. In effect, your "safe" investment would lose value.

If instead you shop for one of the better CD rates and earn 2.5 percent a year, your $10,000 investment would be worth $11,314.08 in five years, and have the purchasing power of $10,247.51 in today's dollars. Not a great return perhaps, but at least you'd be gaining rather than losing value.

How CD owners can fight back against inflation

Here are some things you can do fight back against rising inflation:

  1. Don't settle for yesterday's CD rates. As inflation rises, interest rates typically rise. So, what you considered a good CD rate last year may no longer be competitive next year. Shop around before you simply roll a CD over at the same bank.

  2. Pay more attention to early withdrawal penalties. Early withdrawal is like an escape hatch from a CD, but it comes at a price in the form of an early withdrawal penalty. Like CD rates, these penalties vary widely from bank to bank, so compare penalties when shopping for CDs.

  3. Approach laddering with an open mind. CD laddering is a great way to deal with changing market conditions, but it works best if you adjust the structure of your CD ladder over time. For example, as of this writing, 5-year CDs are paying an average of 13 times the interest of 1-month CDs. That makes a great case for weighting longer-term CDs more heavily in a CD ladder. However, as inflation rises, the gap between long-term and short-term CD rates may narrow, making it worthwhile to increase the weighting at the short end of a CD ladder.

  4. Raise your savings targets. Higher inflation means things will cost more in the future. This may simply mean that you will have to save more money to reach your financial goals.

Generally speaking, inflation is a threat to consumers and investments. Inflation poses a particular threat to long-term CDs, though, because they require you to commit to a rate that may no longer be adequate to beat inflation by the time the CD matures.

Rising inflation could make CD rates more changeable than they have been in recent years, so be prepared to shop for CDs more actively to limit the damage inflation does to your investments.

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