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Stock Strategist

Is Your Money Smarter 'In' or 'On' the Bank?

Between bank CDs and bank stock, we discuss which is the better bet.

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Is it better to put your money in the bank--or bet on the bank? Investors face this dilemma when weighing the choice between bank certificates of deposit and shares of a given bank's stock. In the discussion below, we explain why the decision boils down to how quickly an investor needs to access the funds. That is, there is no one-size-fits-all solution.

When to Buy CDs
We always emphasize that investors need to think long-term. However, investors also need to be willing to commit money for the long term. If an investor expects to need the money he is looking to invest within a short period, then putting money in the bank makes more sense.

Certificates of deposit are one of the most common bank products out there. Customers agree not to touch their deposits for a certain period of time (typically anywhere from one month to five years), and the bank agrees to pay them a set rate of interest--much higher than the typical savings account interest rate--in return. CDs can range in size, but most people buy CDs of less than $100,000--making the deposit FDIC-insured. Therefore, even if the bank goes bust, the customer will not lose any of his principal. At the end of the designated time, the CD "matures," and a customer must decide to either buy another CD or spend the money in some other fashion.

Why would I, as a stock analyst, recommend CDs over stocks? Basically, when you put $10,000 in a CD, the federal government is guaranteeing you will get your money back. Buying common stock comes with much more risk. There is no such thing as principal guarantees for stocks, and stocks can and do go down in value. This could happen in any given year, so unless you have a long-term time horizon, stick with the CDs. Currently, the national average of a one-year CD is 4.84%, which is a safe, solid return for a short-term investor.

When (and Why) to Invest in Stock
When an investor has a longer time horizon (at least three, but preferably five or even 20 years), then I suggest putting your money on the bank--not in the bank--for three principal reasons.

1. You can get paid more now.
2. You get a tax advantage.
3. Your total return is significantly higher.

Get Paid More Now
Dividend yields for some of the best banks in the business are currently higher than the one-year and five-year CD interest rates. Below is a list of highest dividend-yielding U.S. bank stocks we cover. Stocks, such as  Bank of America (BAC),  Wachovia (WB), and  US Bancorp  (USB), are all yielding more than the five-year CD rate of 4.88%. This means that the bank is going to pay you more to hold its stock then it would pay you to keep your deposit!

We realize that not all of these dividend yields are equally safe. The highest-yielding bank we follow,  Indymac (IMB), is an Alt-A mortgage lender. With the turmoil in the housing markets, Indymac's ability to keep its dividend at its current $2 per share is in question--which is reflected in our speculative risk rating. However, there are plenty of banks out there that yield more than 5% and have safe dividends--which are actually growing.  Washington Mutual (WM),  National City  (NCC), Wachovia, Bank of America, and  BB&T (BBT) have all increased their dividends in the last three months. In fact, Wachovia and Bank of America each upped their dividends by a whopping 14%.

 Dividend Yields Among Banks We Cover
Stock Morningstar
Dividend Yield* Risk Rating
Indymac Bancorp (IMB) 9.34 Speculative
Washington Mutual (WM) 6.4 Average
Huntington Bancshares (HBAN) 6.26 Average
National City (NCC) 6.22 Average
FirstMerit (FMER) 6.15 Average
First Horizon (FHN)  Under Review 6.04 Average
Old National Bancorp (ONB) 5.64 Average
Susquehanna Bancshares (SUSQ) 5.42 Average
Wachovia (WB) 5.33 Average
Popular (BPOP) 5.31 Average
Bank of America (BAC) 5.22 Average
U.S. Bancorp (USB) 5.09 Below Average
Fifth Third Bancorp (FITB) 4.83 Average
Citigroup (C) 4.75 Average
BB&T (BBT) 4.73 Below Average
Regions Financial (RF) 4.73 Below Average
KeyCorp (KEY) 4.52 Average
Associated Banc-Corp (ASBC) 4.47 Below Average
*On 09-10-07

Tax Benefits
A long-term stock investor also gets a significant tax advantage on any returns. Interest earned from CDs is considered ordinary income by the IRS. As a result, the long-term CD buyer can pay up to 35% of interest income in taxes. On the flip side, most investors who hold bank stocks over the long term will see dividends taxed at a preferred rate of 15%. This means that the aftertax reward of a stock (held for the long term) that yields 4.88% is greater than the CD that yields the same amount. In fact, for a median-income household (paying a 25% marginal tax rate), a stock would need to yield only 4.3% to get the same aftertax earnings as the current five-year CD rate of 4.88%.

Higher Total Return
Total return for a CD is easy to calculate. If the depositor has the bank mail him an interest check every quarter, the principal balance will never increase and the return will be 4.88%. If he decides to leave the interest in the CD, he will benefit from compounding and earn about 5% during the life of his five-year CD. There is no upside to this; even if market interest rates drastically increase during the life of the CD, the bank will not increase the interest rate on the depositor's CD.

How much an investor will earn during five years invested in a bank stock is much more difficult to calculate. Although there are instances when banks have cut dividends, it is rare, and we believe there is very little chance of that occurring in the average- and below-average-risk stocks we have listed above. However, we think there is a good chance that these banks will increase their dividends during the next five years. This, in turn, will increase the yield on a long-term investor's initial investment.

Pinning down how quickly a dividend can grow is difficult. With most banks paying out between 50% and 60% of their earnings in dividends already, dividend growth is likely going to be constrained by earnings growth. The entire banking industry's growth is limited to something slightly above gross domestic product growth of 5%-6%. While the smaller regional banks might be able to take share and increase earnings faster, the larger banks have a tougher task ahead of them. Although lower than historical growth, 5% is still much better than the 0% growth an investor would get on a CD. Adding a 5% annual dividend growth rate to Bank of America's current 5.22% yield would push the dividend yield on initial investment to 6.7% at the end of five years--much more than the 4.88% someone would still be earning on a 5-year CD.

Comparing the Fruits of a $10,000 Investment
At the end of five years, an investment of $10,000 in a CD earning 4.88% would be worth $12,763 if the depositor took advantage of the compounding interest. A $10,000 investment in Bank of America, without any principal appreciation, would be worth $12,884. If the investor reinvested the dividends instead of spending them, he would have $13,236 at the end of five years.

And then there's capital appreciation. When someone buys a $10,000 CD, the bank will return the $10,000 plus interest after the fixed set of time, not a penny more or less. However, when someone invests in a bank stock, the initial investment might also appreciate. Stock prices fluctuate every day--and I can almost guarantee you that a $10,000 investment in any bank will not be worth the same $10,000 five years from now. No one can predict what a stock will be worth five years from now, but by researching the fundamentals--and buying at a discount to our fair value estimate--we can tilt the odds in our favor. We have 15 five-star bank stocks, all with dividend yields that will generate more aftertax cash returns during the next five years than a CD would. In sum, we believe there are some great opportunities for the long-term investor to put his money in a bank's stock rather than just in the bank.

Jaime Peters does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.