Long Term Impact of 1% CDs
Albert Einstein is supposed to have remarked that a force in nature even stronger than gravity is the power of compound interest.
His words are never more true as we watch the prolonged results of earning what can only be described as chronically paltry CD interest rates. Since the crash of 2008, bank savings rates have tumbled down and have not gotten back up. A one year bank CD pays about 1% interest.
If you are willing to go longer and lock your money up for five years, the national average annual rate is about 1.7%. If you are looking at a bank money market or savings account, you will probably have to count the zeros to the right of the decimal point to figure out how close your rate is to nothing.
And more good news to add insult to injury: this income is subject to income tax. Ouch.
With a 1% annual rate of return, did you know that it will take about 72 years for your money to double in value? But, and here's where Einstein comes in, if you can get just three percentage points more, that is, 4% per year, your money will double in only 18 years. And double again in the next 18 years.
Let's take a look at real numbers. A $10,000 CD earning 1% grows to just $11,961 after 18 years. Yes, my math is correct. However, the same $10,000 earning 4% will have more than doubled, reaching $20,258.
I know what some of you are saying: John, I'm not planning to be around 18 years from now, so what do I care?
And anyway, interest rates are going to return soon to where they were in the good old days.
First, even if you leave this earth anytime soon, or not so soon, most of your money will still be here, to be inherited by your heirs. So it's not just your life span we are talking about, but the life span of your children and grandchildren. Now we could be talking about a duration of 50 years or more.
Second, with regards to interest rates bouncing back, consider Japan's plight. That country has had low interest rates for 22 years now. The United States is only – only? – in its seventh year of very low rates. About five years ago, experts confidently proclaimed that our country is different from Japan, and therefore, we will not experience the same economic slow-growth funk in which Japan finds itself. After all, Japan is a country that has an aging population, large government debt, and growing social programs. Whoops – does that sound familiar? Could Japan's situation, as well as slow growth around the world, portend low interest rates for some time to come for us, too?
What's one to do? Carefully, and I mean carefully, throw some diversification into your savings with securities that pay better income and have a chance to grow. Consider some corporate and municipal bonds, which, though not guaranteed by the federal government, are guaranteed by the issuer and mature to a fixed date with a fixed principal like a CD. Even consider blue chip stocks that happen to pay good income. Did you know that Verizon stock, though its principal is not guaranteed, pays an income rate of more than 4%, and that ATT pays more than 5% annual income? Even good old Duke Energy pays an annual income rate of about 4%.
Remember, 4% may not sound much different than 1%, but over the years, the effect of compound growth will make a huge difference. Einstein was right – again.