Certificates of deposits, aka CDs have long been a stable part of my overall investment portfolio. Whether it was a bull market or a bear market, I would always invest roughly 20% of every dollar saved in the longest CD possible since college. Although I lost around 30% of my net worth during the worst of the crisis in 2009, I knew that even if everything went to hell I’d have at least 20% of my net worth intact. The feeling was very comforting, especially when yields were over 4%.
Unfortunately or fortunately, times have changed and the best 5-year CD rate I can find is roughly 2.4%, slightly lower than the 10-year government bond yield as of 1H2017.
Rates have inched up about 0.5% since Trump’s presidential victory on expectations of higher growth and inflation. However, rates continue to remain depressed and will likely stay low for a long time due to economic slack, productivity growth, and technology.
As a result of lower interest rates for longer, everybody should AT LEAST:
1) Refinance their mortgages, call their credit card companies, and consolidate their student loans. Refinancing a mortgage or locking in a new mortgage at current low rates is a no brainer given the Fed will continue to raise rates in 2017. I refinanced my 5/1 ARM from 2.625% down to 2.375% in August 2016 thank goodness. Best to check the latest mortgage rates and see if they make sense for you.
2) Look for higher returning investment opportunities in a risk appropriate manner. This is where I plan to go deeper with this article for 2017 and beyond.
Always Remember Everything Is Relative In Finance
When you have the 10-year treasury bond providing a ~2.4% return, your hurdle rate is very low. There is a good chance a monkey can randomly choose 10 stocks to build a portfolio that will beat these returns if history is any guide. The dividend yield of the S&P500 alone is around 2.3% for goodness sake. The 10-year bond yield is the hurdle you need to beat to make an investment worthwhile. Otherwise, why bother taking any risk when you can earn ~2.4% a year risk-free.
My conservative investment target return has always been around 2-3X the risk free rate of return. With the 10 year treasury yield likely staying below 3% for a very long time, I’m shooting for a 4% – 7% annual return (2-3X the 10-year bond yield). The problem is, no CD provides even close to a 4% return. As a result, we need to move up the risk curve.
I’ve got a $330,000, 7-year CD earning 4% coming due in 2017, which I plan to reinvest to earn at least a 4% rate of return. I do not plan to renew the CD into another 7-year CD at a 2.4% rate for another 7 years due to the current economic environment. Here are the reasons why:
* Highest rate available is a 10-year CD at 2.5% yield.
* CDs yields barely keep up with inflation.
* Locking up money for 10 years for 2.5% does not sound appealing, especially with an early withdrawal penalty.
* If there is significant 3-5% inflation due to so much monetary easing, CD rates will rise, making it foolish to lock up money at lower rates.
* The S&P 500 dividend yield is around 2.3%, and if Trump cuts corporate taxes and boosts government spending, there’s a decent chance this bull market in stocks may continue.
* Chances are decent investors should be able to outperform a 2.5% return in many other asset classes.
CD Investment Alternatives
1) High Interest Savings Account. For those who are absolutely risk adverse, investing money in a high yielding online savings account is the safest move. You can earn about 1% – 1.2% today. A 1% – 1.2% savings rate where you can freely access your money without penalty is attractive compared to locking your money up for 5-10 years at only 2% – 2.5%. The reason why bricks and mortar banks can’t offer as high of a rate than banks like Ally, Capital One, etc is due to much larger overhead costs.
2) Peer-to-Peer (P2P) Lending. P2P lending has been around since 2006 and has finally started to go mainstream. The industry is regulated by the SEC and there are now loans worth over $10 billion in P2P land. After about 10 years of data, you can earn roughly ~7% in a portfolio of 100, A or higher rated notes. You’ve just got to be OK with borrowers occasionally welching on their debt.
3) The Stock Market / Dividend Stocks. Investing in the stock market is the riskiest CD alternative, but it’s also straightforward thanks to retirement savings vehicles such as the 401k, IRA, as well as online brokerage accounts. Investing in the stock market is not a comparable alternative to risk-free CD investing at all as we learned during the recession. That said, low interest rate returns on CDs force us to take more risks. So far, the S&P 500 has gone up by over 200% since February 2009. The question on every investor’s mind is: how much longer will the good times last?
20% of my net worth is in CDs because I’m content with 4% risk-free returns. 35% of my net worth is in real estate because although real estate is a fantastic way to build long term wealth, real estate is leveraged risk. No more than 35% of my net worth has ever been exposed to the stock market because the 1997, 2000, and 2009 implosions destroyed tremendous wealth and sent many friends to the poorhouse for going all-in at inopportune times.
The easiest way to invest in the stock market is through Wealthfront, the original digital wealth advisor that leverages technology to customize an investment portfolio based off your risk tolerance. It’s free to sign up and explore what type of investment portfolio they might build for you. Further, the first $15,000 managed is free using my special promotional link, and it only costs 0.25% a year as they invest your money in low cost ETFs.
4) Debt Repayment Of Any Kind. It’s generally better to have less debt than more debt. If you have legacy debt that has a stubbornly high interest rate which cannot be lowered, then paying down debt is the safe alternative. Examples of legacy debt include student loans and mortgage rates at over 4% and any type of credit card debt, which averages above 12%.
A 4% mortgage interest rate might not seem like a lot, but when the current risk free rate is less than 2.5%, 4% is sufficiently high enough to pay down. Remember to always think in relative terms. Besides the economics of paying off debt, there’s also a positive mental benefit as well. I paid off my 2.75% business school loan debt early because I simply found the debt annoying. Getting rid of the burden felt tremendously satisfying.
Do note that refinancing your mortgage to a lower rate is considered debt repayment. During the refinance process, a bank literally pays off your entire existing loan and gives you a new loan with a better rate in its place. See the latest mortgage rates with LendingTree. They have one of the largest networks of lenders who compete for your business so you can get the best rate possible. This is exactly what I did when I refinanced my mortgage in 2016. I used the written bids to make my existing bank match and beat their best rate!
5) Bonds / Municipal Bonds. Bonds have historically returned 3% – 5% and have also provided much less volatility than stocks. But bonds have also suffered from a decline in yields along with the long decline in government bond yields. If you are in a 28% or higher federal income tax bracket and pay state taxes, you may want to consider investing in municipal bonds, which allow investors to earn federal and state tax free income.
The risk of investing in bonds now is that Donald Trump’s policies may accelerate inflation, which would push down principal values. I’m personally buying a California municipal bond ETF, CMF, which provides a ~2.5% yield as part of my low-risk portion of my investment portfolio. See: The Case For Bonds: Living For Free And Other Benefits
6) Real Estate Crowdsourcing. Investing in real estate in cheaper parts of the country is currently my #1 focus for where I want to re-invest my money expiring CD money for 2017 and beyond. Instead of investing hundreds of thousands of dollars in one specific property, I’m investing $5,000 – $20,000 in various commercial or residential real estate deals through RealtyShares, the top real estate crowdsourcing platform today. They are based here in San Francisco, and I’ve met with all their top management and done a tremendous amount of research on their company.
Real estate is expensive in coastal cities such as Los Angeles, Seattle, San Francisco, Washington DC, Miami, and New York City. Now that Trump has won, the Midwest, South and other inland cities should attract more attention and outperform relative to coastal cities. They already have much higher cap rates (rental yields) of 8% – 20% compared to just 2% – 5% in the coastal cities.
The average return for real estate crowdsourcing has ranged from 9% – 15% a year for the past several years. I plan to invest roughly $250,000 of my $330,000 in expiring CDs with RealtyShares for 2017 and beyond. Out of their 400+ deals, only 1 has defaulted. By building a diversified portfolio of 10 mid-market deals, I’m confident I’ll be able to beat the 4% CD return.
Saying Goodbye To CDs Is Not Hard To Do
With CD rates so low and alternative investments relatively more attractive, it’s hard to argue a strong case for investing in CDs anymore. Perhaps if you are super risk adverse, already in retirement, and have no other passive income whatsoever, CD investing is appropriate. However even then, a 70 year old can find greater returns in often criticized annuities.
Finally, I also strongly encourage everyone sign up with Personal Capital, a free online wealth management software to keep track of your money. I used to manually update my net worth in an Excel spreadsheet once a quarter. Now everything is done for me so I can spend my time analyzing my overall net worth and making sure it is properly balanced. My number one goal is to continuously grow my net worth in good times and in bad times. Nobody cares more about your money than you!
One of their best features of Personal Capital is the 401K Fee Analyzer which is saving me over $1,700 a year in portfolio fees I didn’t know I was paying. Personal Capital keeps track of my budget, highlights risks in my portfolio, and helps me keep a watch out for pesky bank fees. They’ve even got an amazing Retirement Planning Calculator using your real linked data to run thousands of algorithms to see whether your retirement goals are achievable. See how you stack up yourself! It takes only a minute to sign up and aggregate your accounts.
About the Author: Sam began investing his own money ever since he first opened an online brokerage account online in 1995. Sam loved investing so much that he decided to make a career out of investing by spending the next 13 years after college on Wall Street. During this time, Sam received his MBA from UC Berkeley with a focus on finance and real estate. He also became Series 7 and Series 63 registered. In 2012, Sam was able to retire at the age of 35 largely due to his investments that now generate over six figures a year in passive income. Sam now spends his time playing tennis, spending time with family, and writing online to help others achieve financial freedom.
Updated for 2017 and beyond.