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Are Your CDs Losing the War Against Inflation

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woman_suit_seriousMost people who invest in bank certificates of deposit aren't really getting anything back for the time they tie up their funds.

Sure, CDs pay interest, but in many cases the interest rate is lower than the rate of inflation. When that's the case, it means the money you get back from the bank at the end of the CD's term is worth less than what you put in at the beginning.

This problem can be avoided, but it helps to understand how most CDs are losing the inflation war, and how you can get the better of inflation rates.

CD rates and inflation

According to the Bureau of Labor Statistics, the Consumer Price Index rose by 1.9 percent during 2018. That's a fairly mild inflation rate by historical standards, but still enough to beat most CD rates available.

A recently-completed America's Best Rates study by MoneyRates.com found that 5-year CD rates averaged 1.71 percent. A $10,000 CD invested for five years at that rate would be worth about $10,885 when it matures. Unfortunately, if inflation were to continue at a 1.9 percent annual rate over the next five years, that $10,885 would only have the purchasing power of $9,907 in today's dollars.

In other words, having a CD that pays a lower rate of interest than the prevailing inflation rate means there is a good chance you are signing up to lose value over the CD's term.

Finding banks with the highest CD rates to beat inflation

Fortunately, some banks offer higher CD rates that give you a better chance of beating inflation.

While the America's Best Rates survey found that 5-year CD rates averaged 1.71 percent, 42 percent of the rates in the survey were high enough to beat the prevailing inflation rate of 1.9 percent. This includes 18.5 percent of 5-year CDs that offered an annual interest rate of 3.0 percent or greater.

In other words, higher-yielding CDs may be in the minority, but they are out there for consumers who are willing to shop around for the best CD rates. Many of the top CD rates are offered by online accounts, so these should be accessible no matter where in the United Stats you live.

To compare whether a new CD would do a better job of fighting inflation than a CD offered by your current bank, try the MoneyRates CD rate calculator. This calculator not only allows you to compare two different CD rates side-by-side, but it also shows how much value each rate could gain or lose to inflation over the life of the CD. The same tool can help you identify CD rates that may improve your performance against inflation.

Dealing with unpredictable inflation rates

Finding one of the highest CD rates is a good start in trying to gain an edge against inflation. Even then, the problem is that inflation is unpredictable, and so what starts out as an edge over inflation when you sign up for a CD might not still be an advantage by the time the CD matures. If inflation rises while your CD rate is locked in, it could wipe out your rate advantage.

In addition to rate shopping, here are two things you can do to increase the chances that your CD rate beats inflation. These are both different ways of protecting against the possibility of rising inflation.

  1. CD laddering. Rather than keeping all your money locked up in one CD, consider a CD laddering strategy. CD laddering means investing in a series of CDs with staggered maturity dates. This can allow you to have CDs maturing at regular intervals, giving you multiple opportunities to reinvest the money at new CD rates. If inflation rises CD rates will likely rise as well, so having CDs mature regularly would give you periodic chances to adjust to the rising inflation environment.
  2. Finding a mild early-withdrawal penalty. You should focus primarily on interest rates when shopping for a CD, but you should also pay attention to the early-withdrawal penalty. This is typically a portion of your interest you must forfeit if you withdraw money from the CD before its maturity date. If you find two or more CDs with similarly high interest rates, choosing the one with the lowest early-withdrawal penalty could give you a relatively cheap exit strategy should inflation get out of hand.

A CD is supposed to reward you for waiting. The longer you are willing to commit to a CD, the higher your interest rate will typically be. However, this principle only applies if your CD rate beats inflation. Otherwise, the longer you commit, the more value you lose. That's why taking steps to make sure your CD has a fighting chance in the inflation war is so important.

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