A friend of mine recently e-mailed me to ask what she should do with a five year certificate of deposit (CD) that recently matured. And, my advice to her and anyone who is looking to reinvest the money is to think short term. Interest rates in America will be raising sooner rather than later as the Federal Reserve turns its attention to battle inflation. Of course right now, the Fed has its hands full dealing with the current bailout plan and shepherd the bill through Congress. But, right before the financial market turmoil began, the Federal Reserve was looking hard at inflation in America, and they will be looking at it again once the current crisis has abated.
Fed Funds Rate. Eventually the Federal Reserve will turn its attention to interest rates and inflation. With the cost of milk, bananas, gas, and most other consumer staples rising, there will eventually be talks of battling inflation, maybe not now during this presidency but soon thereafter. A quick lesson on the Federal Reserve. . .a lot of media attention surrounds the Fed Chairman, who is currently Ben Bernanke, and interest rates. In reality, the Fed does not control the rates that you and I earn on CDs or pay for car loans, etc. The Fed controls what is called the Federal Funds rate which is the interest rate that banks and the Federal government charges each other overnight. The Federal Reserve regulates the flow of money through the American economy by adjusting this rate every so often, and it is this adjustment that garners so much attention in the news when the rates move. Raising the Federal funds rate will dissuade banks from taking out inter-bank loans between each other and the Fed. Doing so makes cash that much harder to procure for banks, they raise their rates on CDs and savings accounts in order to draw in more money for operations, and then they pass those rate increases onto the loan customers buying new cars, etc. So, the Federal Reserve’s actions have a trickle down effect on the consumer.
Keeping Money In CDs. So, if you have money maturing in a CD, what do you do with it? You do not want to lock in a fairly low 5-year CD interest rate when rates will be climbing in a few months. A CD ladder is a great way to hedge your best against rising interest rates. A CD ladder is a version of stocks’ dollar cost averaging for certificates of deposit.
If you have $10,000 to invest, you could build a CD ladder like the one listed below where you would invest the money in CDs with staggered maturation dates:
$2,000 in a one-year CD
$2,000 in a two-year CD
$2,000 in a three-year CD
$2,000 in a four-year CD
$2,000 in a five-year CD
As each one-year CD matures, you immediately invest your money into a five-year CD. This keeps one year separating all of your CDs, hence the name CD ladder.
Here is a great website that has a CD Ladder Calculator that you can play around with and get a feel for how much money you would make from this strategy. While you will not squeeze out every last dime of profit that you possibly could using this plan, you will earn a nice return while setting yourself up to take advantage of increasing interest rates when the Fed raises them. Another great example of the earnings differences between CD laddering versus investing solely in one-year CDs can by found this great article on bankrate.com.
Investing In Stocks. If you wanted something better than a CD, most great blue chip stocks (good, big companies) have never been cheaper….same thing with some great mutual funds. Everything has been beaten up these past few months even great stocks that didn’t deserve it. Those stocks have just ridden the wave down with the rest of the market, but I have a feeling that they will be back up very soon.
If you enjoyed this posting, you might also like these:
1. Should Bonds Be a Part of Your Investment Portfolio
2. What the Best Way to Fight a Bear? Invest More!
3. Certificates of Deposit (CDs) Are a Waste of Time!