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As the saying goes, it’s better to be safe than sorry. And for investors seeking safety, guaranteed investment certificates (GICs) can be a useful part of your overall financial plan, as they preserve your principal while returning a predictable amount of interest. Here’s what you need to know to use GICs effectively in your own plan.
What is a GIC?
A GIC works much like a loan–except you’re loaning money to a bank, instead of a bank loaning it to you, and it’s you who is paid the interest. When you purchase a GIC, the interest rate is already determined, so you know how much money you will earn from the “loan.” GICs are considered a safe an investment option, because GIC buyers are guaranteed their initial funds plus interest.
GICs are similar to savings accounts. It can feel similar to just depositing money in a bank account and earning interest. But it can work harder for you. GICs usually earn higher interest returns than the money can in a bank account. The downside, though, is you are agreeing not to use the money in your GIC until the agreed-upon term is over. You can access your funds if you need to, but you may pay steep penalties.
The minimum you can invest in a GIC is typically $500, but it can be higher, depending on which financial institution you’re dealing with.
How does a GIC work?
Why are GICs considered to be safe? It’s because they have two protective measures:
- Financial institutions that issue GICs are legally obliged to repay investors’ principal and interest.
- If a GIC issuer goes bankrupt, your bank account and registered accounts at separate banks and credit unions, which may contain GICs, are eligible for coverage of up to $100,000 each by the Canadian Deposit Insurance Corporation (CDIC). GICs that you own are insured as long as they are issued in Canadian dollars, the term is five years or less and the company that sold it to you is a member of CDIC, a credential that all major Canadian banks hold. Credit unions are members of the deposit insurance corporation of the province where they operate and may have a smaller insurance repayment policy, so check before you open an account or purchase a GIC with a credit union.
These government-mandated standards ensure you are compensated if a CDIC-insured GIC issuer goes bankrupt.
Terms and maturity
The shortest GIC terms are 30 days, but they can be as long as 10 years. In general, the issuer will pay you a higher interest rate for a longer term until maturity.
Like most fixed-income securities, there is a usually costly penalty for withdrawing your money early (i.e., before the maturity date).
Investors who may need access to their funds before their maturity dates should purchase cashable or redeemable GICs—meaning that you can cash your investment at any time with no extra cost. Keep in mind that cashable GICs usually pay significantly less interest.
Types of GICs
There are a few different types of GICs—and understanding what each offers will help you decide which fits your investment needs best. The terms (amount of time you must agree to deposit your money) and interest rates can differ quite a bit. In all cases, though, your initial deposit is protected. (Compare the best GIC rates in Canada here.)
Fixed-rate GICs pay a predetermined interest premium each term. For example, $1,000 invested in a one-year fixed GIC at 2% interest will return $20 of interest plus the original $1,000. This type of GIC is the most commonly issued type. However, it offers no protection against inflation. In this scenario, if the inflation rate is 3%, the purchasing power of your GIC deposit plus interest will be $990 in real dollars, which is even less than the $1,000 you initially deposited.
Some GICs link interest payments to a fluctuating benchmark, usually the institution’s prime rate. These types of investments are called variable-rate GICs and will prevent you from missing out on potential interest-generated gains because your nominal returns grow as interest rates do.
Other GICs link interest payments to an underlying stock market index and are called equity-linked GICs. The interest rates on these are not determined until maturity. If the market underperforms, you may see no return except for your original principal, which is guaranteed.
Escalating-rate GICs increase the interest rate that you are paid over time. Let’s say you buy one that matures in three years. It might pay you 1.05% interest in year one, 1.20% in year two, and 1.65% in year three. These GICs give you a bigger incentive to not take your money out early, as it generates the best return in the last year of its term. Like fixed-rate GICs, this type does not protect against inflation.
GICs also differ based on how often interest payments are made. Issuers let you decide if you want to receive these payments monthly, semi-annually or annually—or they can be automatically reinvested until the maturity date.
Registered and non-registered GICs
GICs can be held in non-registered and registered accounts.
- Non-registered accounts are assets that deposit-taking institutions keep secure, such as a bank account.
- Registered accounts are Tax-Free Savings Accounts (TFSAs), Registered Retirement Savings Plans (RRSPs) and Registered Retirement Income Funds (RRIFs), which allow your investments to grow tax-free. The government encourages Canadians to save more of their income through the incentives included with these accounts.
TFSAs and RRSPs both have contribution limits that are calculated in different ways.
If you have never contributed to your TFSA and you are over 28 years old, you have a TFSA contribution limit of $69,500 as of 2020. (Your contribution room started accumulating after you turned 18.)
Your RRSP contribution limit is calculated based on 18% of earned income that you reported on your tax return in the previous year, for a maximum limit that changes each year. For instance, the maximum is $27,230 for income earned in 2020, $26,500 for 2019, and $26,230 for 2018. Company pension plan contributions reduce your limit; this is the government’s way of ensuring that Canadians with workplace pension plan don’t have an unfair advantage in saving for retirement over those who don’t.
The biggest difference between using these two savings vehicles is that you have to pay tax when withdrawing assets, including GICs, from an RRSP, but not when taking them out of a TFSA. Withdrawals from a TFSA are completely tax-free, and when you make a withdrawal, you regain that same amount of contribution room the following year.
GIC laddering is when you buy GICs that mature at different times, allowing you to collect a steady stream of income that includes both interest and principal repayments. An example of this is buying a one-year GIC, a two-year GIC and a three-year GIC all on the same day.
The benefits of laddering are twofold:
- Laddering gives you greater access to your funds without any penalties, as you have the option to do so every time that one of them matures. Or you can simply choose to reinvest the funds.
- When you are invested in GICs with a range of maturity dates, your interest-rate risk is reduced because you have more opportunities to renegotiate.
GICs vs high-interest savings accounts
We’ve already touched upon how GICs stack up against keeping money in a bank account; but how do GICs compare to high-interest savings accounts? Generally speaking, both are considered safe investments with low-risk interest returns. They are what you would call “guaranteed investments,” as long as you keep the money invested for the specified term, of course.
When you buy a GIC, the terms and the interest rate are defined. But with a high-interest savings account, you have access to that money. Note that the transaction fees, which are higher than the typical savings or chequing account, are meant to deter you from withdrawing money. Also, check with your bank about a required minimum balance. GICs have costly penalties for cashing in on your investment before maturity. Another difference is that the rates on high-interest savings accounts can fluctuate with market conditions and interest rate decisions by the Bank of Canada. (Get a better understanding of interest rates with this primer.) The interest rates for GICs are set and guaranteed when you buy.
Deciding between a GIC and a high-interest savings account really comes down to whether you can commit to keeping the money invested for the specified term, or if you need to be able to access your money (called liquidity).
Are GICs worth it?
You may consider purchasing GICs if you are a fixed-income investor with a short time horizon. That means you need access to that cash somewhat soon. Say, you’re saving up for a down payment for a house, you’re nearing retirement, you’re going to start your own business or have a baby. GICs produce secure income and a safe place to stash your money, although the returns are usually much lower than from a long-term stock portfolio, and may risk not keeping up with inflation. Income-oriented investors who value security over potential returns will benefit from this investment. Just be wary of allocating too much of your portfolio to GICs, even if you are a retired investor, as you may still have many decades ahead.
In the end, the line between safe and sorry varies from person to person, so you have to find what works best for you.
Compare the Best GIC Rates in Canada
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Thank you for the wake-up call. Previously, I was of the opinion, ‘safe is better than sorry.’ Now, I am sorry. My bank tends to sway clients towards GIC’s. I’m not the only one. GIC’s are a bad investment choice for my financial future. Until very recently, I was completely naive about automatic reinvestment. Four years to maturity on the remaining GIC’s. I stand firm on my decision, no matter what my persuasive advisor may say. I foolishly loaned my hard-earned money to the bank. Four years later, ZERO interest. I would say I have not changed….I just woke up!
Thank you. You are the first person to ever actually explain in terms I could understand. I’m still undecided on what to do, but I now have a clearer understanding on what it means.