Waited Too Long to Get the Best CD Rates? Here’s Another Route to Great Passive Income Returns

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You don’t need CDs to have great passive income potential. Check out this other option. [[{“value”:”

With the recent announcement by the Federal Reserve Board that the federal funds rate will be dropped by 0.5%, the cost of borrowing for banks has dropped significantly. That means they won’t be offering the hot rates that have been available until recently on products like certificates of deposit (CDs).

In fact, the yield on savings vehicles started dropping in anticipation of the rate cuts, with 12-month CDs dropping from 5.21% on average in July to just 4.38% on average in September, and 60-month CDs dropping from 4.56% to 3.71% in the same timeframe.

The best rates for CDs have already set sail, but that doesn’t mean you can’t still make plenty of money with your money. There are other vehicles out there that aren’t tied to interest rates, including index funds.

What is an index fund?

An index fund is a specific type of exchange traded fund that you can buy and hold in a few ways. You can choose to buy it as part of your stock portfolio in your brokerage account and hold it just like a stock, or you can use a retirement account like an individual retirement account (IRA) or 401(k) to buy and hold your index funds.

Index funds are extremely low-risk investments because they’re designed to follow specific stock indexes, like the S&P 500 or the NASDAQ-100. These are collections of stocks for the biggest companies in the world, which makes them incredibly reliable investment vehicles.

Although there’s some risk of loss, unlike with a Treasury bond or a certificate of deposit, the risk is quite low. Like with government bonds, if the main components of the S&P or the NASDAQ lose all their value, we’ve got a much bigger economic problem than the loss of some retirement accounts.

Passive income with index funds

Index funds return passive income in two different ways, depending on how the fund is structured. Because they’re bought like stocks and function like stocks, you always have the (very good) chance of making a positive return on your investment simply by buying an index fund and holding on to it for a while.

But index funds also have a yield. This is kind of like interest, but is instead generated from maturing bonds and regular dividend payouts. It’s all earned income, just earned in a different way.

This is often smaller than what you’d get from a bank right now, but remember that the yield is only one part of the passive income from the index fund.

You do have to pay for an index fund, since it’s an actively managed investment. That means it’s constantly being adjusted to maintain its ability to track to the index it’s supposed to follow. You don’t have to do anything active yourself, but companies like Vanguard and Invesco do, and they charge a tiny bit for it.

Usually this is a fraction of a percent of your purchase price, so it’s not a ton. But it does need to be considered when you’re counting how much passive income you ultimately made.

Buying and holding your index fund is the way to big passive income, though, as stated above. But let’s look at how big it can be with a few examples. Remember, index fund returns are not guaranteed, though they are considered very safe and reliable investments.

To put it a different way, if you had bought $1,000 of VOO five years ago, you’d have made $935.10 by doing nothing, plus the yield. Meanwhile, $1,000 of QQQ would get you $1,584.40 today. And VTWO would have earned $490 on your initial $1,000 investment.

So the yield is a nice-to-have trickle of income, but when you sell your index funds, that’s where the potential deluge happens.

Certificates of deposit aren’t the only solid bets in town

CDs are high-quality investment instruments, and they have a near-zero risk of loss. But with the recent drop in the federal funds rate and more likely to come, CDs may go back to producing lackluster interest income as rates continue to shrink.

Index funds, on the other hand, follow the investment markets, and although not foolproof, they do benefit from upward pressure from inflation and a growing economy. Some are certainly more risky than others, but if you choose index funds that are well diversified, you should have no problem coming out with some major income on a long-term time horizon.

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The Ascent does not cover all offers on the market. Editorial content from The Ascent is separate from The Motley Fool editorial content and is created by a different analyst team.Kristi Waterworth has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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