Manage episode 220919817 series 2394901
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
- What a Certificate of Deposit (CD) is
- Why Banks Offer Them
- Why it is a Bad Idea to Put Your Money Into a CD
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.
(Most savings accounts compound daily, loans compound monthly, and CD typically compound annually)
- 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 monthlyThe 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%
$1000 * 1.02 (100% principle + 2.0% interest) = $1020
$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?
- Compound Interest typically would not apply to a 1-Year CD because most CDs Compound Annually.
- 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
- So, in this case, you were promised 2%, and you get exactly 2% interest on your investment at the end...nothing compounded in between
- Let's assume you got a magical CD that compounds monthly...how would that affect your return?
- First, your 2% APR will be Chopped Into 12 Equal Bits...one for each month
- 0.02 / 12 = 0.0016666667
- 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 Investment Compounds)
$1018.49 * 1.0016666667 = $1020.18 (End of December)
Yes, you read that right. In this scenario compound interest will earn you an EXTRA $0.18 over the year.
So, as I said, compound interest doesn't really apply with CDs, especially when you're putting in small money.But Gerald, I'm Big Bank Hank
Cool. I looked at the outcomes for a person dropping $25,000 into a 5-year CD at 2.5% APR.
In that scenario, I ignored the fact that the average Long Term Inflation Rate is 3.22%. Instead, I assumed that inflation would not change AT ALL over the next 5-Years while your money is tied up. Here's the outcome:
- $25000 CD, Compounded Annually, 5-Year Term
- Yields $28285.21 = + $3285.21
- Inflation: $27778.36 buys what $25000 bought 5 years ago
- Net Gain = $506.85 for a 5 Year Commitment of your $25,000
Yes, you gave up access to $25,000 of your money for five years so that the bank could pay you the equivalent of $506.85. Wealthy people don't put money into CDs. If you want to become wealthy, don't put your money into a CD.
Monday, 12 Feb 2018, we will talk about another safe, and much more profitable way to invest your Tax Refund.
Thanks for joining me in this Bonus, App Only Episode.
If you have questions about the numbers we ran or want to dig deeper into this subject, go to the contact tab in the app and Email or Call Me.
If you haven't already, JOIN the Buy Black Podcast Community Facebook Group and let's continue and grow the conversation there!
Talk to you soon!
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