One of the safest savings vehicles in the United States is the Certificate of Deposit, or CD. In Canada, the equivalent of a CD is a Guaranteed Investment Certificate, or GIC.
And while GICs are just as exciting as CDs (don’t bring the subject up during cocktail hour, in other words, unless you want to get rid of an unwanted company), they do have their place in a portfolio. Here’s what you need to know about them.
Similar to their US cousins, GICs pay a set percentage of interest based on the period of time for which your money is locked in. Basically, a GIC is a loan to the bank, credit union or deposit broker. You can often choose to invest for a fixed period of time as little as 6 months to as long as 10 years. The longer the time frame, the higher the interest rate. (You can compare the current rates here.)
You might want to consider going with a GIC term of 5 years or less, as that is the maximum term that the CDIC will insure, with a dollar value up to $100,000.
And much like CDs in the United States, with a GIC you are required to keep your money in the account for the duration of the term. If you need to pull the money out sooner, there may be a penalty or even no interest paid at all. While this defeats the point of investing in a GIC, it’s good to know that you can get at your money if you find yourself in a situation where you need it.
But there are ways around it. You can avoid early withdrawal penalties by investing in a redeemable GIC, which allows you to withdraw your money at any time and still receive the interest you’ve earned up to that point. Of course, there’s a trade off with redeemable GICs, and in that they pay less interest than a regular GIC.
Another thing to keep in mind is that the GIC rate is based on current interest rates at the time you invest in the account. So a Guaranteed Investment Certificate may not be a great investment in low interest environments. This is the risk with a GIC: a low enough interest rate and a higher inflation rate will actually give you a negative real return.
So how can you reduce this interest rate risk? The key is to invest each year as a previous GIC amount matures. This is know as a GIC ladder. Sound familiar? If you live in the United States, you may have heard of a so-called “CD ladder” or “bond ladder”. The concepts work quite the same way in both countries.
For example, if you have $10,000 to invest, you would split out $2,000 amounts in a 1 year, 2 year, 3 year, 4 year and 5 year GIC. Then each year you’ll have one fifth of your investment mature, setting you up to reinvest that amount (plus the interest you earned) for another 5 year term. By using GICs this way, you get the interest rate benefits of a 5-year term, but a portion of your money is available each year. This allows you to benefit from better rates in certain years by reinvesting the money in another 5-year GIC. If interest rates are not so attractive that year, you might decide to put that money to better use in another investment vehicle.
The other risk to your return is that the interest on GICs is fully taxable at your marginal tax rate. You can avoid paying tax be keeping your Guaranteed Investment Certificates in either a TFSA (a Tax-Free Savings Account) or RRSP (a Registered Retirement Savings Plan). While you’ll never pay tax if the GIC is held in a TFSA, remember that you will be taxed when you withdraw for your RRSP.
Not having your interest taxed instantly improves your return — after all, you won’t be losing a third or more of it to the government.
GICs can be a great addition to the income portion of any Canadian’s portfolio, as long as you look to increase your opportunity for higher interest rates and hold them in a tax sheltered account.
Tom Drake is the head writer for Canadian Finance Blog, writing about universal topics such as saving, frugality and earning extra income, as well as Canadian specific topics like RRSPs and TFSAs. Tom’s other site is Money Index, which aggregates all the best sites into one easy to use source for everything finance.