CD Investment Alternatives: Why I’m No Longer Investing In CDs

Hawaiian SunsetCertificates 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 30% 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 30% of my net worth intact. The feeling was very comforting, especially when yields were over 4%.

Unfortunately or fortunately, times have changed due to the Fed’s stance on keeping rates low until 2016 if not much longer. I strongly believe that low interest rates are here to stay for a while. We’ve still got a lot of economic slack in our economy to keep significant inflation at bay. Policy initiatives are also much quicker and more effective thanks to technology. As a result, everybody should:

1) Refinance their mortgages, call their credit card companies, and consolidate their student loans.

2) Be more amenable to taking on debt at the margin to build wealth e.g. buy real estate, invest in a business.

3) Look at all other investments besides CDs.

The best CD interest rate I can find is 2.1% for a 10 year CD. The funny thing is, 2.1% is not bad given the 10-year yield is at around 1.85%. If you deal in LARGE numbers, a 0.3% spread will make you incredibly wealthy! Alas, most of us don’t have billions of dollars to invest and must rely on higher returns to surpass inflation and fund our retirement.

ALWAYS REMEMBER EVERYTHING IS RELATIVE IN INVESTING

When you have a 10 year CD or 10-year Treasury bond providing a 2% 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% for goodness sake.

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 2.5% for a very long time, I’m shooting for 4-6%. The problem is, no CD provides even close to a 4% return. As a result, we need to move up the risk curve.

As my 5 year and 7 year 3.5%-4.5% CDs start rolling off in 2014, I do not plan to renew at 1.5%-2%. Instead, I’m doing research now to invest my money in what will hopefully be much greater returns. Given CDs are part of my risk adverse portion of my overall portfolio, I need to be careful not to invest too far outside my risk tolerance. The rest of my portfolio is split 35% in real estate, and 35% in stocks, excluding all other assets. This mix will start changing as you’ll read below.

To recap why I’m not investing in CDs:

* Highest rate available is a 10-year, ~2% yield.

* CDs yields barely keep up with inflation.

* Locking up money for 7-10 years for under 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.

* The S&P 500 dividend yield is also around 2% and I’m bullish on the stock market.

* Chances are higher we should be able to outperform a 2% return in many other asset classes.

TOP CD INVESTMENT ALTERNATIVES

High Interest Savings Account. The benefit of a CD used to be a much higher interest rate compared to a savings account in exchange for locking up your money for years. Normal spreads were easily 2-3% (200-300 basis points) e.g. 4% yielding 5 year CD and a 1.5% yielding savings account for a 2.5% spread. Even with the national average savings account yield of 0.1%, the spread between an average 5 year CD yield of 1.75% has narrowed to 1.65%. In other words, the return on locking your money up for a long period of time has declined, or the opportunity cost of investing in long term CDs has increased.

I recommend GE Capital Bank with a 0.9% interest rate compared to 0.1-0.2% money market yields on average. A 1.00% savings rate where you can freely access your money without penalty is a no brainer compared to locking your money up for 5-10 years at only 2%. Online banking is the best place to park your cash and it’s very convenient to deposit or withdraw money. Don’t let traditional banks get away with paying you nothing in interest as you fall way behind due to inflation!

Peer-to-Peer (P2P) Lending. P2P lending has been around since 2006 and has finally started to go mainstream. The genre is regulated by the SEC and there are now loans worth over $1 billion in P2P land. I’m investing my money with Prosper.com, which advertises an average 10% return on investors since 2009 who are diversified with over 100 notes, and $2,500 (100 notes at $25 each). Please spend some time to read my 1,500 word review of Prosper.com to get an idea of how P2P lending works and the potential returns.

The average returns range from 5.49% for lower risk, AA rated borrowers up to 12.46% for high risk, HR rated borrowers. As my goal is to beat the risk free rate of return by 3X, investing in AA rated borrowers for a 5.49% is actually a perfect alternative! When I decide to get more aggressive with P2P lending, I’ll move up the risk curve. I don’t expect the total return of the stock market (returns + dividends) to average more than 8% a year for the next five years. If we do get 8% a year, we should all consider us lucky. As a result, once I get a proven track record of ~5-6% returns, I will invest more.

If you would like to join me in building wealth as an investor through Prosper you can sign up here to earn 3X the current 10-year risk free yield. I plan to roll my CD money earning 3.5-4% into P2P lending as my CDs come due.

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 such as E*Trade, where I’ve been a customer for the past 11 years. 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 move up on the risk curve.

30% 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.

If my 8.8% return prediction holds true for the S&P 500, then it behooves me to allocate more of my net worth towards the stock market and away from low risk investments. A 6.8% buffer (8.8% – 2%) should be enough to compensate for risk. Companies are raising their dividend payout ratios more aggressively, meanwhile bonds look as unattractive as CDs. Just remember you can and will lose money in the stock market. It happens to the smartest investors who dedicate their lives to investing. The best thing we can do is have a balanced portfolio that matches your risk tolerance.

If you are interested in opening an online brokerage account, I do all my non retirement investing through E*Trade where I have been a client for the past 13 years. You can trade free for 60 Days at E*TRADE Securities LLC.

Debt Repayment Of Any Kind. It’s generally better to take on debt in a low interest rate environment rather than pay off debt. However, 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.

A 4% interest rate might not seem like a lot, but when the current risk free rate is less than 2%, 4% is a lot. 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.

Structured Notes. Structured notes is a derivative of straight equity investing in the stock markets. Structured notes are a great way to protect your downside while participating in some upside albeit capped. The risk to structured notes lies in the viability of the issuer. If Citibank goes bankrupt, owners of structured notes become a creditor. There is no $250,000 FDIC insurance per individual. Below are three examples.

Example: S&P 500 35% downside barrier note with a 24% guaranteed return or greater after 5 years. Let’s say the S&P 500 is at 1,360 when you spend $100,000 for the note. Unfortunately the economy is horrible and the S&P500 goes down by 20% to 1,088 during the note’s 5 year time frame. When the note comes due, because the S&P500 is down less than 35%, you collect $100,000 principal back + $24,000. If the S&P500 is actually up by 50% during this time period, you collect $100,000 principal back plus $50,000. The downside is the five year lock up and no dividends. If all goes well, it’s like getting at least a 5% annual return + upside. See chart below for details.

S&P500 Barrier Structured Note

Structured notes might seem confusing at first, but with enough research you’ll understand they are simply an alternative way to invest in equities that provides downside protection in return for capping upside returns. There is almost always a minimum six month lock-up period as well. Banks earn money through origination fees and making a margin on your captured dollars. If you are interested in investing in structured notes, go to your local mega bank and ask to speak with a private wealth manager.

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.

I do not include real estate because it is not a proper comparable given landlords must actively manage their properties in person. The CD investment alternatives must be as low maintenance as possible where even if you disappeared off the face of this earth, the returns will still keep coming. If you want to take a baby step, definitely park your money in an online bank such as GE Capital Bank with a 0.9% interest rate vs. 0.1-0.2% on average for money markets as you think things through.

I also strongly encourage everyone sign up with Personal Capital, a free online wealth management software to keep track of your money. I use 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. 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 a Charles Schwab 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.

Photo: Waikiki Sunset, 2013.

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Sam started Financial Samurai in 2009 during the depths of the financial crisis as a way to make sense of chaos. After 13 years working on Wall Street, Sam decided to retire in 2012 to utilize everything he learned in business school to focus on online entrepreneurship.

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Comments

  1. says

    I agree, and would recommend an investment like Kinder Morgan (KMI) over a CD. (But not the Master Limited Partnership (MLP) Kinder Morgan (KMP), due to the K-1 tax form requirement).

    KMI increased its dividend to $0.37 for Q4 and $1.40 for the year, ahead of even the revised budget of $1.35 for the year. At it’s last close and annualizing that $0.37 to $1.48, the forward yield is 3.96%! Way better than a CD, and not even considering that this dividend should rise over time.

    • says

      I agree on the (KMI) recommendation. I purchased shares for my dividend income portfolio last year and have already seen two dividend increases in that time. Plus, they are predicting strong dividend growth over the next five years.

      Larry

  2. Investor Junkie says

    Sam I agree on your statement, but unfortunately we are all Pavlov’s dog doing what the FED expects us to do. With CDs of mine coming due I may still put some into CDs. Just a very limited amount.

    No mention of I-bonds??? No dividend stocks?

    MLPs are part of my portfolio for income, but don’t think it’s a good time to get into them now. I’ve seen 100% appreciation (this does even include the income) in the MLPs I own current so it’s a very crowed space (like all income producing products)

    REITs also as well, but not in taxable account.

    • David m says

      I’ll mention I-bonds, I have over $200,000 worth of them. I purchased over 10 years ago and my fixed rate is 2 to 3.6 percent. Thus over the
      Ast few years I have been getting 5 to 7 percent interest.

        • David M says

          I absolutely agree!

          I bonds now only return inflation – with no fixed amount above that.

          All other bonds – the risk to reward ratio just is not there in this low interest rate environment.

  3. says

    Great post Sam. The only thing I can think to add is a bond ETF.

    If you’re willing to step up on risk for higher yields there’s always a short-term junk bond ETF like SJNK. Average maturity is 3.5 years, modified average maturity is 2 years, and it has a YTM of 6.1%. Very little rate risk compared to other bond funds but there is significant credit risk. Crazy diversification helps a lot there. Not comparable to a CD in any sense, but yields are much higher.

    • says

      Thanks for your suggestion on the bond ETF. Unfortunately, I don’t think such a bond is an appropriate replacement for risk free CDs. There’s too much risk in bonds IMO, especially at current low rates. I can’t see bonds in general climbing much higher.

      I’m bullish on equities and expect bonds to underperform or lose investors money as the great rotation towards stocks occurs.

  4. says

    From your list, I like structured notes. I don’t know much about it, but it sounds like safe investment. Peer to peer lending and stocks are much more risky than CD.
    I’m not investing in any new CD either. The rates are just too low. I’ll wait until the rate is better to buy some long term CDs.

  5. says

    This makes a lot of sense. I have not put money into a new CD in years. My focus now is in low-fee mutual funds for my retirement account, more risky equity investments in my shorter term investment account, and a nice cash cushion for whatever might come up next.

  6. Doug says

    Hey Sam, I was wondering if you ever spent time looking at the human capital websites like upstart.com. I have been poking at them and I think I like p2p lending more, but extra discussion on the subject couldn’t hurt.

    -Doug

    • says

      Sorry Doug. Haven’t looked into upstart. I like how payment is capped, regardless of your success. However, if one has the capital, best to capture 100% of the upide if you’re putting in 100% of the effort. Thx

  7. says

    I’m a big CD ivestor myself. I don’t have any maturities coming up soon but I will definitely consider pulling my money out when the time comes. I find structured notes intruiging and can see myself going that route as a replacement. I don’t have the patience to put together and monitor a dividend stock portfolio. Thanks for the tips Sam.

  8. says

    I started to move some money into TIPS a few years ago. I have a Vanguard fund that yielded 6.78% (2012), 13.24% (2011), 6.17% (2010) & 10.80% (2009). So far this year, it is slightly negative, but overall I like it as an alternative to CDs.

  9. says

    I think it all depends on what you want to do with the money. I would only invest parts of my emergency fund or some short term savings in a CD (although a high yield savings account might be a good alternative). Otherwise, I’d stick to dividend paying stocks.

    I’m a little bit leery of P2P lending and wouldn’t feel comfortable with any more than 10% of my money invested there.

    If I was particularly wealthy, I would look into structured notes.

    • says

      I was leery about P2P lending for the first 5 years until 2012. It’s SEC regulated, defaults have dropped, and there is data showing positive returns from 2009-2012 e.g. during the financial crisis.

  10. says

    I’m very curious about P2P. I’d love to hear your results if you go in that direction. Right now, even though it is not completely passive, I would invest in real estate. It is incredibly cheap in my area and there will always be a large pool of renters due to socioeconomic reasons.

  11. geek says

    Quicken loans was ok and they’re quite nice, but my credit union had a better Apr so we’re going with them. Except we’re also reducing the length of the loan, so our monthly goes up but overall (we plan to rent this place out when we buy another) we spend 30k less. Our original mortgage was last April!

    Next up: REITs

  12. Dan23 says

    As I understand it you will end up paying ordinary income tax on your structured notes gains. Is that correct? I vaguely remember reading once that that has to be the case if there is principal protection or something like that.

    You are also exposed to credit risk of the issuer (generally a bank), so without going into priority of payments if your expected return on structured note does not exceed debt of that bank that is maturing at a similar point, it is probably not a good idea.

    • Financial Samurai says

      Correct. If you think Citibank is going bankrupt, then you probably don’t want to buy structured notes from Citibank. But if Citibank goes bankrupt, the world will probably return to chaos.

  13. says

    I have a little bit of money that I need to keep very safe for the next year. I am saving for a newer car and I need to keep the money in a place that I can’t touch. A guaranteed income certificate (GIC), the Canadian version of a CD, is the way to do it.

    I am working very hard to get out of debt and I don’t want to go back in debt when it is time to trade in my car.

    ING Canada is offering 12 months at 1.35% and 18 months at 1.75%. There is a 5 year at 2.25% but I will need the money before then.

  14. JayCeezy says

    We are still investing in CDs, even at these low rates. Yes, they barely keep up (or not) with inflation. Yes, the income for after-tax CDs is taxed as regular income. Yes, there is no opportunity for growth with CDs. My portfolio is heavily weighted to CDs and MM funds, because I intend to step off the work treadmill very soon, and cannot tolerate the risk of a 10% (or more) haircut. I am happy to allow my portfolio to slowly erode in value over decades, while eliminating the chance of getting slaughtered by Fed decisions, profligate Govt spending, declining dollar value, irrational herd mentality, spring-loaded inflation, etc. CDs are my only option at this point in time.

    Stocks, Bonds, Real Estate, Gold, etc. all have big downsides which have been discussed in prior FS blog posts (and as Sam stated elsewhere, are not comparable to CDs). The disturbing thing about Stocks is that there is no longer a correlation between the economy and the Equity markets; this break in reality and predictability has discouraged us from further investment. Some of the posters appear to be newer investors, and I would like to point out 3 things: 1) The S&P 500 (75% of US stock market) returned exactly 0.0% for 2011, less the dividend. Yet all that money was at risk. 2) The S&P 500 is lower today than it was in 2000, 13 years ago. 3) The NASDAQ is 60% of where it was in 2000; $1 invested 13 years ago is worth 60 cents today, less dividends.

    Those 3 things may bounce off investors happy with a 100% run-up in the past 5 years, and I am not encouraging anyone to take my path. Just wanted to explain why CDs are the best deal for me. One more thing, btw, I don’t understand the need/desire to build an Dividend portfolio of individual stocks; there are plenty of low-cost Dividend/Value funds that do this very thing and require very little care-and-feeding.

    • says

      Thanks for sharing your viewpoint. Each person’s situation is different and this choice let’s you sleep best at night, especially what you mentioned before regarding your portfolio loss during the downturn.

      So many folks were making fun of me for allocating 30% of my savings to 4% yielding CDs when the markets were going up. They said I wouldn’t keep up with inflation. Well, I’d much rather have a 4% guarantee than lose 30% of my principal in the market that’s for sure. Losing out to inflation is different from losing money!

  15. says

    Another idea.

    Check out your local credit unions. Sometimes they offer a member advantage account where you earn a much higher rate on the first $500 or $1000 in the account. For example, anyone living in Washington State can apply to be a member of Boeing Employees Credit Union and sign up for their member advantage program.

    https://www.becu.org/Default.aspx

    Then you earn 6% on the first $500 in a checking and $500 in a savings account. It ends up being $60 bucks a year and the requirements are really simple. E statements and a monthly transfer into the account of as little as $10.

    You can also open up accounts for the kids (Early Saver Accounts) and earn the same rate on the first $500.

    Larry

    • David M says

      My Credit union has something different but also a great way to get a “juiced up” return.

      You put $500 a month into a special saving account and they pay 4% interest on the amount in this account. This not going to make me rich but it’s a little extra “free” money.

    • says

      Hi Larry, I checked a couple credit unions here in SF, and some do have some good rates. I guess I can’t be bothered to physically open up an account given it’s so easy to open up an account online nowadays and transfer money. Call me 2013.

  16. says

    You must check out government I savings bonds. They are bought online at treasurydirect dot gov and are guaranteed to protect your cash from the ravages of inflation. The interest payments reset 2 times per year in accord with the inflation rate!

  17. Mattman says

    Earlier you said you were not a fan of bonds. Have you considered a short term investment grade bond fund? Some of these have been paying 4%-5% over the past few years and with the short term duration, you will not be hurt that bad by an unexpected spike in inflation.

  18. Marcel says

    Sam,

    Thanks for the CIT Bank recommendation. A 1% yield is amazing compared to what BAC or WFC were offering. Next step, figure out what to do with the Vanguard Total Bond Fund, which everyone is saying is about to blow up.

    Marcel

  19. says

    Sam, have you written an article to compare the various brokerage accounts? I’m curious what you find in Etrade as compared to the alternatives. I haven’t used Etrade myself but if they have good research, etc, I would consider switching. I’ve been considering making a switch for awhile but I really havent made the time to analyze the options out there. When I choose my account 8 years ago, I didn’t have much to invest so I just choose my account pretty much randomly.

  20. says

    What about an already mature Whole Life Policy? Many of the mutual companies (150+ Yr companies) are paying 5 to 7% dividends that (when used correctly) could be tax free.

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