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The Threat to Your Savings in CDs and Money Funds: Inflation

written by: wearmanyhats•edited by: Laurie Patsalides•updated: 2/26/2010

It's wonderful to have investments that are liquid and safe. However, they are at risk from inflation, too. This article explains how inflation erodes savings in CDs and Money Funds.

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    When the stock market drops the way it did in 2008, people run to the safety of money market accounts or certificates of deposit. While these investment vehicles are considered liquid, insured, and safe, there is one problem with them: they tend to lose their value through inflation.

    CD Rates vs. Inflation

    Inflation, and the subsequent erosion of purchasing power, is one of those problems that are often tolerated by investors, since people store their money in a money market just for a short time. Certificates of deposits and money markets retain their basic value at all times, which makes them especially attractive during stock market downturns. Basically if you put in a dollar, you will get that back, maybe with a little interest or dividends.

    So why don’t people put their money into CDs or money markets funds all the time? Simple, inflation eats away the purchasing value of these investments. This is critical for anyone understanding how to use money effectively.

    Consider putting $100.00 into a CD that is earning 3% a year in interest. At the end of the year, you would be rewarded with $3 of interest.

    However, suppose the inflation rate was running at five percent. Let’s say that the same $100.00 at the beginning of the year could buy ten wamboozles. At the end of the year, you would have to come up with an additional five dollars to buy those same ten wamboozles. That is the insidious nature of inflation wearing on the money funds. Returns on the safest money vehicles are never as high as inflation.

    If you need your cash to remain highly liquid, these short term savings are fine. However, if you have more time to make a higher return, consider passing by the certificate of deposit and money market to keep inflation from eating away from your portfolio.

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    photo by James Stewart