Income For LifeCertificates of Deposit or CDs are a great place to put money, right? Well, the answer depends on if you are the bank or the customer.
As a customer you give the bank your money and agree to leave it there, at the risk of a penalty, for a certain period of time, usually anywhere from three months to five years. In return, you are paid an interest rate that is better than a savings account or money market rate.
The bank takes your money and loans it out to other people at an even higher interest rate and makes a profit on the difference. The bank makes more money but they also deserve to profit. They guarantee your money and take the risk that a potential borrower doesn’t pay it back. The bank’s reward is justified for the risk they take and the guarantee they offer depositors.
So far, it looks like a fair deal. In simple form, each party should be happy with the terms.
But look beyond that relationship for a moment to see what else is going on outside that relationship. Your money is safe, no doubt, but are you really getting ahead?…..
Most people don’t realize that money is susceptible to many eroding factors. Among these, taxes and inflation are two of those factors I would like to focus on. As we have explored in other areas of this site, taxes can seriously affect investment returns. In just the same fashion, inflation can be every bit as damaging.
Let’s look at this by way of an example. We’ll buy a CD, hold it for a year and adjust the earnings for taxes and inflation and see how much we have left. Let’s start with $100,000.
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Assumptions:
4% CD interest rate
3% inflation
40% tax bracket
| Initial Investment | 4% Interest | Less 40% Tax | Purchasing Power |
| $100,000 | $104,000 | $102,400 | $99,328 |
Wow! That is not an optical illusion. In this scenario, after one year in a CD where inflation is a realistic 3%, the power of your money has actually decreased.
Now, in other areas of the site, we talk about protecting your money from taxes. The inescapable truth is that inflation can make any investment look a lot less desirable. If you want safety, you must find a place for cash that moves ahead of the rate of inflation. Taxes make that job even more difficult.
As popular and safe as bank CDs are, the Straight Talk is that you are doing nothing more than losing money safely .
