026-B: Don't Put Your Tax Refund Into A CD!

Certificates of Deposit (CD) Make You Lose Money

This is a quick bonus episode for all of you who have downloaded the Buy Black Podcast App!  It's not going to any of the directories so if you know someone who needs this info (and so many of us do), help them download the app on their phone as well.

Points We Cover In This Episode

1. What a Certificate of Deposit (CD) is
2. Why Banks Offer Them
3. Why it is a Bad Idea to Put Your Money Into a CD

Supporting Concepts:

APR: Annual Percentage Rate

Compound Interest: Additional return on investment that you get when your principle investment PLUS previously accrued interest are multiplied by your APR

Compounding Schedule: How often the interest on your investment or loan is compounded.

• Daily
• Monthly
• Quarterly
• Semiannually
• Annually

(Most savings accounts compound daily, loans compound monthly, and CD typically compound annually)

APY: Annual Percentage Yield

• APY is the actual rate of return that you receive on your investment based on your interest compounding schedule
  • More simply, how much more money you're getting ABOVE the APR because of Compound Interest

Inflation: The rate at which the cost of goods and services increases over time.  This fluctuates and is reported monthly

The Numbers

Current Best CD Rates

• 1-Year: 1.8% APR
• 3-Year: 2.0% APR
• 5-Year: 2.5% APR

In the episode I use the examples of a 1-Year CD with 2.0% APR (not realistic...absolute best case investing scenario), and a 5-Year CD with 2.5% APR (typically only available with minimum $25,000 deposit).

Current Inflation Rate

Average inflation for 2017 was 2.13%.  I use that number throughout the episode.

The Math

We use a $1000 tax refund example, putting it into a 1-Year CD at 2.0%

Investment:

$1000 * 1.02 (100% principle + 2.0% interest) = $1020

Inflation:

$1000 * 1.0213 = $1021.30

Net Value Loss of $1.30

***The person I first discussed this with argued that I wasn't accounting for Compound Interest...so let's work through that***

What About Compound Interest?

1. Compound Interest typically would not apply to a 1-Year CD because most CDs Compound Annually.
   1. This means the only time interest would compound on your CD is the day you close it out and retrieve your money from the bank at the end of the year
   2. So, in this case, you were promised 2%, and you get exactly 2% interest on your investment at the end...nothing compounded in between
2. Let's assume you got a magical CD that compounds monthly...how would that affect your return?
   1. First, your 2% APR will be Chopped Into 12 Equal Bits...one for each month
   2. 0.02 / 12 = 0.0016666667
   3. So, your interest would be compounded at a rate of 0.16666667% each month

$1000 * 1.0016666667 = $1001.67 (End of January)

$1001.67 * 1.0016666667 = $1003.34 (End of February)

$1003.34 * 1.0016666667 = $1005.01 (End of March)

(Here, you see the benefit of Compound Interest because rather than having a simple return of $1.67 each month based on your original $1000 principle, the return each month gets slightly larger because interest accrual is based on a higher amount that is in your account after each additional accrual.  Because of this, your APY gets higher the more often that your Loan or Invest