Yes, there's no denying it: Interest rates are abysmally low right now. Understanding "why" and the impact on your bottom line, can make a big difference in how you use C.D.'s in the future.
What are interest rates anyway?
Simply put, interest rates can be defined as the “Cost of Capital”, which to put in regular language just means the 'cost of doing business'. Let's take a look:
If rates are high, for example, your new home loan interest rate will be high. Similarly, for businesses looking to borrow money, higher rates for borrowing become prohibitive, so business expansion declines. Low rates, on the other hand, provide impetus for more borrowing and expansion because we say "money is cheap"; ultimately if done correctly, that spells “growth” and a stronger economy.
What causes rates to go higher?
A high-growth economy i.e. a strong business cycle will lead to higher interest rates. READ: Demand increases, rates go up. Cost of goods also increase and we have inflation. Inflation just means what a single dollar may have purchased yesterday, today now requires more than a dollar for the same item.. In so many words, the effect of which: your money has ‘shrunk’. Currently we’re in a phase of low-demand, low-growth and therefore virtually zero inflation. A healthy economy is one that strikes just the right balance between growth and demand. Not too hot, not too cool. That’s why the Federal Reserve has intervened to make rates low – to stimulate growth.
What does it mean to my bottom-line?
First it’s important to understand what the yield on a C.D. actually "Nets" you in the end. While an 8% rate on a C.D. sounds very attractive, there are two fundamentals that we often forget to consider in understanding the "Net" effect. The two things we consider to get the "Net" are "inflation" and "taxes".
As we said, inflation means, in most simplistic terms, your dollars are shrinking and buying less.
Some of you will remember that in 1981, you could get almost 17% interest on a C.D.! Sounds too good to be true? Well, it did happen. However, inflation was also running at 11%. So that means, by the end of the year, your money – including the amount you earned on the CD - had shrunk by 11%.
In effect, that 17% rate of return only netted you 6%, after adjusting for inflation’s impact. Then if we apply the second impact on your "net", you also have to pay taxes on the full amount of interest you earn. You can see that, after inflation and taxes, you’re practically at ground zero.
Lessons Learned
Today’s rates are incredibly low, but so is inflation. In the relative sense, there is nothing unusual about today’s rates.
If you’ve refinanced your home mortgage (or taken out a loan for business expansion, etc), you’ve benefitted from these very low rates. Low inflation also means we’re not experiencing rapid price increases when we go to the store for clothing, food and other goods and services. Again we’re benefitting from low inflation.
C.D.s were never meant to be an “investment” – they are simply a place to “park” money safely.
"Investing" by definition means you are attempting to “grow” your money. Growing your money means you have to first outpace inflation and taxes before you see any real growth.
Simply said: CD’s, money markets, interest bearing checking accounts provide a minute fraction of growth and should not be thought of as an investment vehicle.
So while we may feel that we are being penalized by today's low rates, remember that high rates mean high inflation ... something we all want to avoid. So go ahead and keep your emergency money in C.D.'s, but remember that the only investment in today's environment - that provides a hedge against inflation and taxes is in the stock market.
Comments