Definition and Examples of Inflation-Protected CDs
A certificate of deposit is a special type of deposit account that typically will earn a higher amount of interest than a standard checking or savings account. Unlike other types of investments, most certificates of deposit are insured by the FDIC for up to $250,000. While a CD may sound like a good idea—it can return a better rate than your regular savings account, after all—certificates of deposit also carry risk, especially when the rate of inflation outpaces the interest you’re accruing. Inflation-protected CDs seek to remedy this problem. Both standard CDs and inflation-indexed CDs will maintain interest rates as set by the bank, but the latter will pay out interest based on how much inflation has occurred as measured by CPI. This index is commonly used to measure the level of U.S. inflation.
Alternate names: Inflation-linked CD, inflation-indexed CD, certificates of deposit inflation-protectedAcronym: CDIP
How Inflation-Protected CDs Work
A certificate of deposit works like this: You buy a CD from your bank, agreeing to hand over a lump sum of money for a certain period of time. In return, you’ll receive accrued interest on that money while the bank is free to use it for its own purposes. Once the CD expires, you’ll receive all your funds back in addition to any interest you’ve accrued. The length of your CD will depend on what you choose; some can be as short as six months while others can last for several years. Let’s say you decided to invest in a 12-month CD nearly a year ago. Rather than going for an inflation-linked CD, you opted for a standard CD, which provided an interest rate yield of 0.03%. You anticipate needing flexible access to your funds, so rather than dropping your entire savings into a CD, you’ve chosen to invest just $1,000. At the end of the year, your CD will become mature and you will have earned $3.61. However, inflation over the last 12 months has averaged 7.5%, meaning that your money is worth 7.5%—or $75—less than it was when you parked it in the CD. Although you’ll have earned $3.61, overall you’re still down $71.39 as compared with the $1,000 you originally invested. If you had opted instead for an inflation-protected CD, you would have accrued the interest rate designated by your bank, but also would have received additional funds to ensure that your money wasn’t affected by inflation.
Is an Inflation-Protected CD Worth It?
An inflation-protected CD could be worth it if you’re looking to shield yourself against any downside represented by the consumer price index. However, CDs in general aren’t necessarily the best possible investment. In fact, six-month CDs haven’t had a positive return on the investment since 2008, once you factor in taxes and inflation. Of course, you’ll receive higher rates on your CDs the longer that you have them, and you can always opt for different kinds of CDs. Step-up CDs, for example, can offer a variable interest rate that is higher than a regular CD’s. Or you might consider callable CDs, which allow banks to cancel your deposit prior to its maturation date. Due to its increased level of risk for you, banks are generally willing to offer higher interest rates for these CDs. You always take on some level of risk when choosing to invest, but it might help to look at these inflation-protected options in the face of steadily climbing prices—or you’re guaranteed to lose money each year with many CDs.
