Guaranteed Investment Certificates (GICs) provide a safe investment vehicle, providing guaranteed returns. In exchange for depositing your funds for a specified term (e.g., 1 year), the financial institution will return your funds with interest at the end of the term. The term can span anywhere from a couple months to up to 5 years, which begs the question, is a 5-year GIC worth it?
Generally, 5-year GICs will severely underperform other investments. Even at a GIC interest rate of 5% or more, the opportunity cost of a GIC can be very high. Furthermore, GICs restrict access to your funds. This means that you may be penalized if you take your money out early.
Though there are circumstances where GICs may make sense, purchasing a GIC as a long-term investment will provide less growth than other investments.
What is the Opportunity Cost of a 5-Year GIC?
The opportunity cost of an investment is the difference between the actual returns, and the potential returns produced elsewhere. For this example, we’re going to compare the returns of a 5-year GIC to investing in the S&P 500 over a 5-year time frame.
With a GIC, the 5-year rates can range from about 2% to around 5%, compounded annually. Using the compound interest formula (see below), over a 5-year time frame, you could expect your money to grow by 10.4% and 27.5% respectively. So, if you started with $10,000, at the end of 5 years you would have between $11,040 and $12,750, depending on the actual rate of your GIC.
Now let’s compare that to investing in the S&P 500 (see breakdown below). Since 1957, the average compound interest rate over a 5-year time frame has been 10.3%. Over a 5-year investment at this interest rate, your money would grow by 63.2%. So, this same $10,000 investment would turn into $16,320.
This means that by storing your money in a 5-year GIC, your opportunity cost is between 5% and 8% gain annually. Depending on your initial principal, this could result in huge amounts of money. And if you extend this past the 5 years, the opportunity cost just grows.
Now one thing that isn’t demonstrated in this example is the risk. GICs represent a guaranteed return, whereas stock markets are subject to volatility. Though the average 5-year return is 10.3%, it can vary from as low as -12.5% to 28.6%.
If you can’t afford to lose the money, GICs may be a good option. That said, GICs lock your money in, so you need to consider if you can give up that money for 5 years.
What is the Net Gain on a 5-Year GIC?
With multi-year GICs, the interest rate is typically compounded annually. What that means is that the base capital grows in year 1 based on the interest rate. Then, in year 2, the base capital and the year 1 growth would grow by the interest rate. This results in exponential growth, and compounding has been called “the eighth wonder of the world”.
To calculate the net gain on a 5-year GIC, we can use the following formula:
Assuming the amount compounded once per year, this equation can be simplified to: A = P*(1+r)^t. For now, we can ignore the principal (you’ll see why in a second).
Let’s compare two rates of return, representing possible GIC rates. Please note that you would need to check the interest rates are at the time you’re reading this if you wanted to replicate this calculation, but for this example we’re going to use 2% and 5%. Using the above equation, over a 5-year time frame, the two rates will result in the following amounts of growth:
- 2%: 10.4% growth
- 5%: 27.6% growth
If you started with $1,000 (this is the principal we removed earlier), for the 2% and 5% rates, at the end of 5 years you’d have $1,104 and $1,276 respectively,
For sacrificing access to these funds for 5 years, these are not very high gains.
What is the Average Stock Return on a 5-Year Investment?
Since 1957, the average returns over a 5-year time frame have been 10.3%. Now this represents the average, but by no means can be presented as the expected return. In reality, the 5 -ear compounding rate can vary wildly:
As you can see, the 5-year return can vary from as low as -12.5%, to as high as 28.6%. Now if we use the 10.3% as an approximation, using the compound interest rate calculation presented above, we can calculate an estimate for growth on your money. Over a 5-year time frame, money invested at a return of 10.3% will grow by 63.2%
So, if you invested $10,000, it could grow to $16,320. Not bad for passive wealth creation.
Can You Lose Money on a GIC?
One huge advantage of GICs is that they are a very safe investment. Unlike the stock market which can rise and fall, GICs will only go up. In exchange for this safety, GICs will provide a lower rate of return.
Furthermore, as suggested by the name (Guaranteed Investment Certificates), GICs are insured by the CDIC up to $100,000. This means that even if the bank fails, the government will ensure you don’t lose money. For you to lose money on a GIC, the government would have to fail, at which point you’d likely have greater problems than losing your money.
Now with this said, you need to recognize that you’re losing access to this money for the term of the GIC. As well, though there won’t be a decrease in the dollar value of your GIC, there are two costs to be aware of: Inflation and opportunity cost.
As mentioned above, the opportunity cost of a GIC is the returns you’re missing out on. But inflation may be quietly reducing the value of your money, so though the dollar amount has increased, the purchasing power may have decreased.
Does a 5-Year GIC Pay Interest Annually?
The payout schedule of a GIC depend on the specific terms, and may be monthly, annually, or at the end of the selected term. Review the terms of your GIC to see the payout schedule.
If paid out at the end of the term, 5-year GICs do typically compound annually. This means that in year one, the base deposit amount grows by the interest rate. Then in year 2, the base deposit and the year 1 growth will grow by the interest rate. This compounding can create exponential growth on your funds over the long-term.