According to Bankrate.com, the national average for a 1 year CD is 0.48%. With CD rates at these historic lows, many investors are looking for other investment options.
WHO can blame them?
Just to illustrate, that means in exchange for tying up $10,000 for a year, a bank will pay you the hefty sum of $48.
Furthermore, if for some reason you need your money and cannot wait until the maturity date, they will likely charge you a penalty.
To be fair, I am painting CDs as the bad guy here, but they also have redeeming qualities. They are guaranteed by the FDIC (up to $250,000 per depositor per institution), and they do not fluctuate if held at a bank or credit union. Simply put, they grow very slowly, and they never go down. In this environment, that is enough for some people. For most others, this is what happens:
Client: “I am looking for something that pays more than the 0.75% the credit union is offering.”Me: “What type of risk are you willing to assume?”Client: “Oh, none. I want it guaranteed. No risk. But 0.75% is ridiculous.”Me: “What rate would make you happy?”
Client: “I am not looking for much. Something like 4-5% per year.”
Me: “So, what you want is a guaranteed investment that pays 5% per year. Sir, if that existed, I would have to rent a Brinks truck to carry all of the money we could gather. Lets talk about reality. The alternatives we have are….”
There are several alternatives to CDs, but please understand that all of them carry more risk. Even if the risk is minute, there IS risk and that is why it pays more than an FDIC insured CD. There is a reason that CD rates are very low, and if something pays more, that is because you are assuming more risk. Here are some alternatives:
Government Bond: Backed by the full faith and credit of the issuing government, but as of this writing, the rates are no better than CDs and they fluctuate…meaning that if you buy a 2 year bond, the value can change while you own it. If you hold to maturity, you will get your original investment back, but during the holding period, the market value will change.
Corporate Bond: This type of bond is backed by the issuing corporation. The higher the quality of the company, the lower the interest rate. A Wal-Mart bond pays less than a US Airways bond. As long as the company is still in business on the maturity date, your investment will be returned. However, a word of caution here, companies such as Worldcom (gone), Enron (gone), and AIG (bailed out) were all investment grade companies at one time. The bottom line is that when buying a corporate bond, you are essentially betting that a company will be in existence on the maturity date, and you are being rewarded for that.
Fixed Annuity: These can be a good alternative to CDs, as long as the risk is understood. Think about a fixed annuity being like a CD issued by an insurance company, without the FDIC coverage. As long as the insurance company is around when the annuity matures, you will get your money back. If not, then you won’t. In that sense, they are similar to a corporate bond, but fixed annuities offer fixed interest payments and do not fluctuate.
There are dozens of alternatives available, but all of them have “disclosures.”
After studying all of the issues, choose the best alternative.
The same thing applies when shopping for CD alternatives, but make sure that the issues are disclosed and that you are okay with the additional risks.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and are subject to availability and changes in price.
Fixed annuities are long-term investment vehicles designed for retirement purposes. Gains from tax-deferred investments are taxable as ordinary income upon withdrawal. Guarantees are based on the claims paying ability of the issuing company. Withdrawals made prior to age 59 ½ are subject to a 10% IRS penalty tax and surrender charges may apply.
Government bonds are guaranteed by the US government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value.