Certificates of deposit (CDs) have been paying interest rates of 2% or less for several years now. But you might be surprised to learn that they didn't always yield so little. In the early 1980s, some CDs were paying as much as 18%. Of course, inflation was much higher then, too. So does it make sense to buy CDs in an environment of rising inflation? Here is what you need to know about CDs, as well as some possible alternatives.
- Investing in CDs may not make sense in a rising inflation environment because you could be locking in your money at too low a rate.
- There are some types of CDs and other relatively low-risk investment products that adjust for inflation, although they also have their drawbacks.
- If you want to get out of a low-paying CD, your best bet may be to wait until it matures rather than pay early-withdrawal penalties.
How Rising Inflation Affects CDs
CDs, unfortunately, are not the ideal investment for an inflationary environment. If the interest rate on a CD can't keep up with inflation, your money loses purchasing power. That is especially true of CDs with longer terms. While they pay somewhat higher rates than short-term CDs, they also lock your money in for a longer period, subjecting it to greater inflation risk. If you want to get your money out before the CD's term ends, you'll typically face early-withdrawal penalties, which can cost you all of the interest your CD has earned and possibly some of your principal.
"The real yield on some of the best CDs I could find are still around -6% annually," says Nate Hoskin, CFP, a financial advisor with Hoskin Capital, a wealth management planning service. "Yes, it's better than keeping cash on hand, but there are far better options."
For example, most high-yield savings accounts (HYSAs) pay about as much as a CD, with no early-withdrawal penalties. Plus they also enjoy one of the major advantages of CDs: insurance coverage from the Federal Deposit Insurance Corporation (FDIC) or National Credit Union Administration (NCUA).
Depending on how much risk you are willing to take, there are also other alternatives.
Some Alternatives to Standard CDs
While standard CDs pay a fixed interest rate for a set period of time, there are several types of CDs that will adjust their interest rate if inflation heats up (or cools down). These certificates are sold under a variety of names: inflation-linked CDs, inflation-protected CDs, inflation-indexed CDs, certificates of deposit inflation-protected (CDIPs), variable-rate CDs, and bump-up CDs.
These products can give you some inflation protection, but they also have their downsides. One is that your initial interest rate may be lower than the rate available at that point on a traditional CD. Another is that your rate could fall if inflation declines—a particular danger if you happen to buy your CD just as inflation is peaking.
The most often recommended alternative to CDs is series I U.S. savings bonds, commonly known as I bonds. An I bond carries about the same liquidity risk as a CD (you can't cash it out until you've had it for 12 months). And while it isn't FDIC- or NCUA-insured, it has essentially zero risk of default because it is backed by the government.
The upside is that I bonds adjust their interest rates every six months in line with inflation. As of April 29, 2022, they are currently earning an interest rate of 7.12%. "This is a far better alternative," says Hoskin. Plus, the interest is tax-free on the state and local levels.
I bonds will earn interest for 30 years unless you cash them in sooner. There is no penalty for cashing one in after five years. You can buy an I bond for as little as $25 or as much as $10,000.
Other relatively low-risk alternatives to CDs include Treasury inflation-protected securities (TIPS). Like I bonds, TIPS are tied to changes in the Consumer Price Index (CPI), specifically the CPI-U. (They pay a fixed interest rate, but your principal will increase when inflation rises.) TIPS are available for $100 and up, in $100 increments, and with terms of five, 10, or 30 years. Like I bonds, they are exempt from state and local taxes.
Floating-rate notes are still another possibility. These are government or corporate bonds with rates that will "float" as the index they're linked to rises or falls. You can buy them through a brokerage firm or in the form of a floating rate mutual fund or exchange-traded fund.
Getting Out of Your CDs
If you're locked into one or more fixed-rate CDs that are losing ground to inflation, you have several options, none of them ideal.
- You can simply wait until the CD's term ends, take the money, and reinvest it in something else. (Make sure you give your bank or credit union instructions when the time comes, or it may just roll the money over into a new CD, locking you in again.)
- You can take your money out prematurely and pay an early-withdrawal penalty. These penalties can be relatively steep, so you may not come out ahead even if you immediately put the money into a better-paying investment.
- If you have a brokered CD purchased from a brokerage firm or independent sales agent, you can get out of it by selling it on the secondary market. However, your CD's low interest rate will make it less valuable, compared with newer, better-paying CDs, and you may have to sell it at a loss.
Where Do You Buy I Bonds?
The primary way to buy I bonds is online, at TreasuryDirect.gov. You can also buy them using your tax refund when you file your federal income taxes for the year.
What Is the CPI-U?
The CPI-U is one of two consumer price indexes that the Bureau of Labor Statistics (BLS) uses to track inflation. It stands for CPI for All Urban Consumers and, according to the BLS, covers about 93% of the total population. The other CPI is Wage Earners and Clerical Workers (CPI-W). The CPI-U is generally what the government or others are referring to when they cite the CPI.
What Is a Bump-Up CD?
A bump-up CD is one that allows you to request an increase in your interest rate (a "bump up") one or more times during the CD's term if rates are rising in general. If rates are falling, you can stick with your existing rate.
The Bottom Line
While high inflationary environments are never a great thing in general, inflation poses a particular threat to fixed-rate investments like certificates of deposit. If you're looking for a place to invest in a time of inflation there are any number of alternatives, some just as safe as CDs, others a bit riskier.