Primer on Investing in GICs
October 30, 2023 Leave a comment
With the interest rates rising over the past year, GIC investing has become more popular. A GIC is a Guaranteed Investment Certificate issued by a financial institution. The rates of return have gone from close to zero per cent to around 5% in a short time. There are some nuances to keep in mind when investing in GICs.
The first question to ask with respect to GIC investing is: when do I need the money? If the answer is indefinite because it is a retirement account or more than 5 years from the day you are investing, this concern is not that important. If you need the money for any purpose before the 5 year mark, then the term to maturity should be less than the expected date when you will need the money. If the money you are investing is for emergencies or for an uncertain outcome, GICs may not be the best option because you may not be able to turn the GIC into cash at any given moment.
The parameters you will need to consider to invest in GICs are how much money you want to invest, how long to invest it (or when is the maturity date), and what are the terms of the GIC investment. The rate of return would be one of the terms of the GIC since the interest rate is also dependent on other factors. A GIC is in fact a loan that you are making to the financial institution, and the financial institution is paying you back with interest after a certain time.
Interest Rate
What are these terms of the GIC investment? The first parameter is the interest rate. The rate will depend on how long the money is invested, which institution it is in, and in which account you are holding the GIC. A financial institution will have a table of maturities such as a return for 6 months is 4%, a return for a year is 5%, a return for 2 years is 4.5% etc. Note that these returns are based on an annual basis. A 6 month return of 4% means that you would actually be receiving 2% since the actual money you are receiving is for 6 months. As an example, if you have $1000 and invest in a GIC for 6 months at 4%, the dollars you are receiving in interest after 6 months would be $1000 x 4% x 6 months / 12 months = $20. If you invested for 3 years, and the posted rate is 5%, you are getting 5% each year for the 3 years that the money is in the GIC. Using that $1000 as an investment, the 5% would be $50 per year or $150 once the GIC mature or the 3 year period is over.
What about compounding of interest? The standard method that GIC interest is calculated assumes that the interest you are earning while the money is invested in a GIC will get reinvested until the maturity date. This means that interest will be earned on the interest being generated. How frequently this compounding happens will be one of the terms of the GIC contract. Using $1000 for 3 years at 5% interest, the amount of interest received if compounded annually is calculated as $1000 * (1 + 0.05) ^3 – $1000 = $157.63. Notice that the interest amount is $7.63 higher than if the interest is not compounded.
The formula for compound interest is: the amount invested x (1 + annual interest rate) to the power of (number of years invested) – the amount invested, or I =A (1 + r)n – A.
Note that the interest rate provided will depend on which institution you go to (it pays to shop around), what term you are investing for and what type of account the GIC is held in. An identical GIC for 1 year at CIBC can be 4% for a TFSA account, 4.3% for an RRSP account and 4.1% for a non-registered account. Always inquire about the account where the GIC will be held when shopping for interest rates and terms.
Other Terms
What other terms are there? There are a series of terms that exist with respect to access to your money, payment frequency, return calculation and other situations. When the GIC matures, the principle or amount invested and all of the interest is paid back to you. What about the time between when you invest and the maturity date – when the investment ends? You can have interest payments paid each month, quarter or year instead of all at the end of the GIC term. You can elect to “cash in” or redeem your GIC before it matures but the rate of return would be lower if you have this option. This option is called a cashable GIC. In some cases, you can cash in or redeem your GIC before the maturity date, but you may lose some or all of the interest earned. There may be penalties if the GIC is cashed in before the maturity date. These terms will have to be examined for the actual situation at hand. A fixed rate means you will get the same rate of interest up until the GIC matures. A variable rate means that the rate can change depending on what the interest rates are in the general market. A locked in GIC is a GIC that you generally cannot cash in before maturity without some kind of disadvantage, but with a cashable GIC, it is possible to cash it in without penalties. A market linked GIC is a GIC where the interest earned can be driven by the performance of a stock market instead of the posted interest rate. There are many terms associated with this type of GIC including extra fees, including how the return is calculated (it will depend on what market the return is based on and whether this market goes up or down over the time to maturity), and what happens if you cash in before maturity. This type of product is specialized and it should be used for a different purpose than investing money to earn interest only.
GIC Strategies
Besides learning the terms, knowing what you want to achieve and shopping for the most appropriate deal, what other strategies are there?
The first one is money allocation. If you have $10,000 to invest, you can put it into one GIC, or several GICs adding up to the total amount you would like to invest. Each GIC can have different maturities, terms and conditions. You can customize your whole GIC portfolio depending on what you want to achieve and what your circumstances are. This can also mean buying GICs in multiple accounts or multiple institutions. If you have a self-directed brokerage account where you trade securities like stocks or mutual funds, you can buy GICs from most institutions in one single account. Sometimes, a self-directed account can offer higher rates of return depending on the institution. If you have larger amounts of money, you may get a higher rate of return than the posted rate. This will depend largely on your relationship with the institution you are dealing with and how competitive the GIC market is.
You can also average interest rates or change allocations depending on what the interest rate outlook is. The interest rates are generally set by central bankers with influence from the bond market and the institutions providing the GICs. There are situations where interest rate forecasts tell you that future interest rates will rise or decline. This may mean you would want to put more money into a higher interest rate GIC as opposed to waiting for a later date and receiving a lower rate of return. If you want to optimize your return on your GIC portfolio but don’t want to watch interest rates, there is something called a GIC ladder. This is when you take the amount of money you want to invest, divide into portions and invest in several GICs with different maturity dates. An example is when you have $10,000, and invest $2000 in a 1 year GIC, another $2000 in a 2 year GIC, and so on until you have 5 allotments of $2000 ranging from 1 to 5 years in maturity. Why do this? You would essentially be receiving an average rate of return over all of the maturity dates over 5 years, so if interest rates rise or decline, you would have a steady rate of return. Each year, one portion of your portfolio would mature and you would be able to reinvest the money. To keep the ladder going, you would invest in the longest maturity date so that the average is preserved. In this case, you would invest in a 5 year GIC each year.
GICs can be a great place to invest if you want to keep your market risk low. There is some learning that can be done to get the most from your GIC investing and to avoid any surprises.