What “Guaranteed” Really Means in Personal Finance

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What a "Guarantee" Really Means When It Comes to Your Money

By: Rick Kahler, CFP®

When you hear, “It’s guaranteed,” what do you think of? Safety, reliability or predictability? Certainly these can all describe a guarantee.

However, another side to any guarantee often isn’t immediately visible. A guarantee always includes “fine print,” the conditions under which it will be honored. It also comes with a cost: a higher price, lower return, less opportunity, loss of freedom or commitment.

The Cost of a “Guarantee”

A company selling a product with a guarantee is taking a bet that either the item won’t break or you won’t file a claim when it does. To cover its risk, the company sells the product at a higher price.

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The insurance industry operates on this principle, as well. You pay premiums to them in exchange for a guarantee of payment in case of a loss or expense. They “bet against you,” hoping the catastrophe they are insuring you against never happens while the policy is in force.

The concept is the same with investments. Any time you put money into a product that guarantees you won’t lose money, guarantees a certain return or puts a floor under your potential losses, you are paying a premium of some type.

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How Guarantees Work

Take a certificate of deposit (CD). This is money you loan to a bank for a set period of time. The bank agrees to pay rent for use of your money (the interest rate) and guarantees you won’t lose a dime.

What is the cost of the guarantee? On a CD, it’s the difference between the interest rate you receive from the bank and the rate you would receive from a large corporation with a high credit rating. For example, the recent Bankrate.com national average on a five-year CD is 2.27 percent. Conversely, if you purchased a five-year corporate bond with an AAA rating, with no guarantee of repayment, you would earn about 5 percent.

To assess your risk of making the non-guaranteed investment, you would want to find out what percent of loans are made to corporations with AAA ratings default. That figure is about one-half of 1 percent. The cost of insuring against an event that has less than a 1 percent chance of happening will cost you 60 percent of the return. This would appear to be a very costly premium.

Is a Guarantee Worth It?

Sometimes paying for guarantees makes good sense, such as buying auto, home and liability insurance. In certain circumstances, a guaranteed but low-return investment like a CD might be the best place for some of your savings.

At other times, paying extra for a guarantee is a waste of money. An example might be buying an extended warranty on an appliance that’s unlikely to need service. Some types of insurance guarantees (flood insurance in New Orleans, anyone?) require such high premiums that they rarely make sense.

Next time you hear “It’s guaranteed,” don’t think only in terms of reliability, safety and predictability. A guarantee may well indicate all those qualities. But those two words always come with a price tag, as well. And that’s guaranteed.

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Rick Kahler is a Certified Financial Planner™ professional licensed with a registered investment adviser that provides personal financial advice online for a flat fee. He is an author of four books on financial psychology and recognized by BusinessWeek magazine as one of the 15 most experienced financial planners in the nation. Contact Rick for help with virtually any financial need.

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