CDs and Risks

Effective cash management strategy is central to the success of any financial plan. With strategic cash management, you can preserve liquidity and collect interest to make timely bill payments, purchase big-ticket items, and set money aside for investments. As part of your cash management plan, you may explore the possibility of putting money into a certificate of deposit (CD). Be advised that the CD product does expose you to interest rate and inflation risks.

Identification

A certificate of deposit is actually a loan that you make out to the bank. You accrue interest on your principal until the CD matures in the future. CD interest rates generally increase with longer maturity dates. The bank turns a profit when it invests your certificate of deposit cash at a higher rate of return than your associated interest rate. To make investments, the bank relies upon your principal loan as a steady source of capital. As such, the bank levies early withdrawal fees to discourage you from closing out the CD before its maturity date.

FDIC Insurance

As bank deposits, the FDIC does guarantee CD principal and accrued interest. For 2011, you can take advantage of $250,000 worth of FDIC coverage at each bank that you patronize. As a large saver, you would therefore divide one lump sum into multiple CDs at different banks to secure higher levels of FDIC coverage. For example, you would divide $700,000 into seven different $100,000 CDs at seven different banks to insure the whole amount. Putting $700,000 into one CD would leave $450,000 without FDIC protection.

Interest Rate Risks

As a CD saver, interest rate risk describes an economic environment where interest rates are moving higher. At that point, you may be locked into a 5-year CD that only pays out 4-percent interest, while new 5-year CDs offer 7-percent rates. The Federal Reserve Board hikes interest rates to shield a strong economy against inflation. Interest rate risk is more of a concern with lengthier maturity dates. With a one-month CD, you can move relatively quickly to take advantage of higher interest rates. At maturity, you would roll over the old CD into a new certificate that offers additional interest income.

Inflation Risks

Inflation describes a rising price level for goods and services, which erodes the future purchasing power of your CD interest and principal. The Bureau of Labor Statistics Consumer Price Index pegs the average domestic inflation rate at three percent each year. In terms of purchasing power, you may actually lose money with a CD. Negative real returns occur when the inflation rate exceeds your interest rate.

Investment Strategy

You should purchase stocks and bonds alongside your CD to manage inflation risks and invest for growth. Within your CD portfolio, you may incorporate laddering to preserve liquidity and guard against interest rate risks. With a CD ladder, you would take out certificates of varying maturity dates. For example, you may put money into a one-month and one-year CD. If rates were to rise, you can roll over the one-month CD at maturity into a new certificate at a higher rate. If rates were to actually fall, the one-year CD would allow you lock in favorable interest income.

CDs and Risks, Sources:

SEC: Certificates of Deposit - Tips for Investors

Federal Reserve Board: Purposes and Functions

Bureau of Labor Statistics: Consumer Price Index

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