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High Interest Savings Accounts vs. GICs: What's Better?

There is only one investment type that’s guaranteed to make money – a guaranteed investment certificate (GIC). The upside to GICs is that they’re totally guaranteed: both interest and principal. Whatever it says the interest rate is, that’s what you’ll get. The downside is that you’re locked into a term, and if you redeem (if you’re even allowed to) you forfeit your interest. For a rate that may be less than 1% higher than a high-interest savings account, are GICs ever worth it? What’s better, GICs or savings accounts?

 

Benefits of GICs

Like I just said, the biggest draw to GICs is the G(uaranteed) – you can’t lose money. Not only does the financial institution guarantee your return in writing, GICs with terms of 5 years or less are covered by Canada Deposit Insurance Corporation (CDIC). The CDIC ensures that even if the bank fails, you will get your principal back. GICs may be the safest investment on the planet.

GICs can also be bought in a Tax-Free Savings Account (TFSA) or Registered Retirement Savings Plan (RRSP), so you don’t have to pay tax on the interest. Unlike stocks, where you’re taxed on the capital gains, GICs are taxed as interest income – not tax-advantaged at all. The benefit of putting a GIC in your TFSA or RRSP is that you skip paying taxes altogether, saving 20% or more of your investment.

Let’s run through an example. The best 5-year GIC rate on RateShop.ca right now is 3.35%. On an investment of $5,000, you would earn $837 at the end of the term, assuming it wasn’t compounded. If it was compounded annually, your total return would be $895. That’s nearly $900 completely risk-free.

 

Downsides of GICs

All that safety comes with a downside, though. GICs have low interest rates. In some cases, a GIC may not even beat inflation, meaning that you lose value over time even though you’re earning interest on it.

Inflation Risk

If inflation rises by an average of 2% per year (the Bank of Canada target) then your real return on that $5,000 investment would be 1.35% instead of 3.35% - the equivalent of $400 in today’s dollars. The actual amount of money you receive doesn’t change, just the value of that money in the future.

It’s unlikely for inflation to outpace a 3.35% GIC, but short-term GICs often have interest rates of 2% or less. With those rates, if you don’t put that money to better use once the GIC matures, you’ll end up losing money even while you’re earning interest (money is funny sometimes, isn’t it?). And if the rate is under 2%, you’d be better off with a savings account anyway.             

Opportunity Cost

Something else to consider before buying a GIC is the fact that you’re locking up your money for the length of the term. The issuer of the GIC may or may not allow early redemptions, so you better be really sure you don’t need the money. If they do allow redemptions, you may forfeit some or all of the interest gained. Your principal is never at risk.

Having cash on hand is useful for taking advantage of unforeseen opportunities that pop up. If an amazing property comes up for sale or a company you’re interested in just went public, you can use your cash to buy in – you can’t do that with a GIC. You’ll get your 3.35% (or thereabouts) but you’ll miss out on an investment that could potentially earn you much more.

Interest Income is the Worst

When you hold an investment, there are three ways in which you may be taxed:

1.      Interest Income      

2.      Dividend Income

3.      Capital Gains

Capital gains and dividend income are tax-advantaged, so you’d pay less in taxes on a capital gain of $5,000 than you would earning that $5,000 in interest. Interest income is taxed at your marginal (highest) tax rate, meaning if you make $50,000/year in Ontario you would owe 29.65% in taxes. That lowers your return on that $5,000 GIC from $895, if compounded, to $629.

Avoiding the Downsides

If you can’t be sure that you won’t need the money, but want to buy a GIC anyway, you can buy something called a redeemable GIC (sometimes called a cashable GIC). A cashable GIC will let you take cash out of the GIC whenever you want, but the interest rates for these are generally lower. In fact, the interest rate on redeemable GICs are often lower than a normal high-interest savings account.

A technique you can use to keep your investment safe but also accessible is the GIC ladder. Instead of buying one 5-year GIC, you divide that money by 5 and buy 1-, 2-, 3-, 4-, and 5-year GICs. As each GIC matures, you get the cash back and decide what you want to do with it. If no opportunities have come up, you buy a new 5-year GIC. Every following year, you repeat the process.

The idea behind the GIC ladder is that a portion of your investment will always be available every year, and the rest continues to earn the best GIC rate.

 

Benefits of High-Interest Savings Accounts

There are a couple benefits to savings accounts, not the least of which is that your money is always available. Unless you have a specific bank account which has increasing interest rates for larger balances (e.g. Scotiabank MomentumPLUS Savings) then you’ll always get the same rate no matter how much money you have in there. Adding money to a savings account is easy too – just deposit it like you would your normal bank account.

Flexibility is not something that can be quantified in the same way that interest rates can, and is therefore overlooked in my opinion. You don’t want to miss opportunities because you were unable to move your cash. Riskier investments, like stocks, have the downside of being able to go down in value – but at least you can sell whenever you want. Cash in a savings account has the downside of not earning much interest but at least you can spend it how you like.

Like with GICs, you can have TFSA high-interest savings accounts which give you tax-free interest. If you’re worried that you’re wasting your TFSA contribution room by filling it with low-interest savings accounts, remember you get the value of all withdrawals back at the beginning of the next calendar year.

 

Downsides of High-Interest Savings Accounts

Inflation Risk (again)

Aside from redeemable GICs and chequing accounts, there’s nothing that gives you less interest on average than a savings account. Even the best savings accounts in Canada have interest rates that barely beat inflation some years.

Opportunity Cost (again)

You’ll avoid losing 20% or more of your investment in a market downturn, but you’ll also miss out on gains in an economic boom.

That’s about it, really

There’s not much downside in saving your money. That means you’re not spending it on frivolous things, which puts you ahead of most people. You might be able to do better than savings, but you can do much, much worse as well.

 

So which is better?

That depends on what your needs are.

One of the cornerstones of personal finances is to have an adequate emergency fund set aside in a high-interest savings account. The buffer of between 3 and 6 months’ expenses will save you from relying on credit to get by after an emergency car repair or surprise bill.

If you already have your emergency fund and are just looking for safe investments, consider your time horizon. If you have five years or less until you need the money (such as you plan on buying a home in five years and need a down payment) then a 5-year GIC or GIC ladder can be a good way to make sure you have that money when you need it. If your goal isn’t as clear, such as you want to move to a new city but are waiting for a good job offer, then locking your cash up in a GIC may not be the best idea.

 

If you’re longer than 5 years from your goal, consider investing it in riskier places. If you’re worried about losing your money, remember this: no one who has stayed invested for 25 years has lost money. 5 years may have a couple years of a downward trend, but over time a well-diversified portfolio will almost always increase. Consider the world’s worst market timer – a thought experiment where someone only invested at the worst possible times, days before each major market crash in the past 40 years. He still would come out ahead in the end, if he was able to weather the storm.

 


Chris Chris 02/06/2019
Canadian personal finance buff and all-around writing enthusiast, Chris loves breaking down complicated money ideas to show that they're really not so complex. 
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