How does a GIC work?

If you’re looking for a low-risk way to invest, GICs might be for you. Considered one of the safest ways to invest, you can’t lose your money with guaranteed investment certificates (GICs) because – as the name suggested – they’re guaranteed.

GICs are essentially loans you make to a bank, generally over an agreed upon fixed period. The bank guarantees that you’ll receive your investment back at the end of the time period, plus interest.

In essence, a GIC is like a savings account. You put away money and earn interest on it. But obviously there are a few differences. So, let’s learn more about GICs.

What is a Guaranteed Investment Certificate (GIC)?

A GIC is an investment product you can buy from banks and financial institutions. You agree to your investment term and the interest rate at the outset. Typically, there’s a minimum investment of $500 and the term lengths can be as short as 30 days but are often fixed at one to five years, or sometimes up to 10 years. The term ends on the agreed GIC maturity date and that’s when the bank will pay back your investment plus your earned interest. With most GICs, pulling your money early results in a penalty.

The great thing about GIC is the “G” in the name. They’re guaranteed. This means that, even if your bank went bankrupt, your money is safe. GICs are insured by either the Canada Deposit Insurance Corporation (CDIC) federally or by the province your GIC was bought in. This insurance is automatic – it’s built into the product.

When you buy a GIC, you’re basically agreeing to loan money to the bank. They take your investment and loan it out to other customers at a higher interest rate than you agree to receive back. So, a bank may agree to return your investment at the end of your term plus 5 percent interest. During that period, however, they may have loaned that money to another customer at 8 percent interest. That’s how it works – the bank makes money and you make money.

Types of GICs

When you start exploring GIC options, you’ll see some different routes you can take.

Fixed-rate GICs

Fixed-rate GICs are the most common type of GIC. When people talk about GICs, they’re most likely talking about this type. These products pay out a fixed interest rate, meaning you know exactly what your return will be when you sign up. Say you invest $1,000 into a GIC with a fixed rate of 4 percent for one year, you would receive back $1,040 when the GIC reaches maturity.

Variable-rate GICs

With variable-rate GICs your potential earnings are at the mercy of the market. If you choose this option, your interest payments will be determined by your bank’s prime rate. If interest rates are high, you get more money; if the market is low, you may get very little. As with all GICs, even if the market tanks you’re at least always guaranteed to get your investment back in full.

Equity-linked GICs

Equity-linked GICs, or market-linked GICs, are – as the name suggests – linked to the stock market. These GICs are also variable and pay a return based on the performance of the stock market. If the market is climbing, so is your return. And if the market droops, you’re still guaranteed your investment back.

Escalating-rate GICs

Escalating-rate GICs have guaranteed fixed rates but the rates increase over time. Like a standard fixed-rate GIC, the rates are agreed when you sign up. The difference with escalating-rate GICs is they have multiple agreed rates. For example, you might buy a three-year escalating-rate GIC, it might pay 2 percent in the first year, 3.5 percent in the second, and 5 percent in year three. The incentive here is to invest for longer to get the greatest returns.

Cashable GICs

Cashable GICs, or redeemable GICs, allow you to withdraw money when you need it. Where most GICs will penalize you for pulling your investment out early, cashable GICs do not. You’re not locked into a set term, which gives you more flexibility with your money. The trade-off for this flexibility is lower interest rates.

Registered and Non-registered GICs

A GIC that’s registered with the Canadian federal government means your investment grows tax-free. This would be the case if your GIC is purchased within your tax-free savings account (TFSA) or your registered retirement savings plan (RRSP), for example. With a registered GIC, you won’t pay tax on the interest your GIC earns.

A non-registered GIC is any GIC bought outside a registered account. These do not have any tax benefits and you’ll need to pay tax on your returns. But, as you don’t have any age or contribution limits with non-registered investments (like you do with RRSPs and TFSAs), you can invest as much as you like in non-registered GICs.

How Do You Choose a GIC?

With so many GIC options, it can be difficult to choose what type is right for you. There are a few questions you can ask yourself before you decide.

How long do you want to invest?

This is important. Your money will be locked up in the GIC for a predetermined length of time. And if you want to maximize your returns (and not be penalized for early withdrawal), you need to leave it in there. Short-term GICs are usually offered at three, six, and nine month terms. Long-term GICs are often between one to five years, though some will go as long as 10 years. So consider how long you’re comfortable locking up your investment in this type of product.

Will you need access to your money?

If locking money into an investment you can’t access is unappealing, that could rule out the longer-term (and possibly even short-term) fixed GICs. If you might need that money at the drop of a hat, you don’t want to be locked in. If that’s the case, narrow your focus onto cashable or redeemable GICs. You can pull your money from these easily without penalty. That convenience means your returns will be lower, though.

What is your tolerance for risk?

If you have a low risk tolerance, you’ll likely want the safety of guaranteed returns. Fixed-rate GICs and escalating-rate GICs will pay out at agreed rates. You’ll know exactly what you’re going to get when your investment matures. If you have a higher risk tolerance, variable-rate GICs and equity-linked GICs might scratch your itch. If you go this route you have the opportunity to earn much more, if the interest rates or markets soar. The flipside is that a downturn in the economy could mean your returns are lower than if you’d fixed them.

What Are the Risks of Investing in GICs?

GICs are regarded as low-risk investment products. For good reason. Knowing you’re guaranteed your investment back removes a lot of the risk. And, if you choose a GIC with a fixed rate, you also know for certain what your return will be. But even though they’re low risk, they’re not no risk. Here are a couple of potential issues or hiccups you might encounter.

You want to get your money out before the GIC term expires

Most GICs will penalize you for withdrawing your money before the term has expired, or you may not even be able to withdraw. When you buy a GIC, the agreement is generally that you’ll leave your money in the GIC until the investment has matured. There may be a financial penalty to break the GIC contract, or you may be locked in. This decision is often at the discretion of the bank.

If you absolutely want the freedom to remove your money early, consider a cashable or redeemable GIC. With this type of GIC, you are able to withdraw your investment without penalty.

Your GIC may not keep pace with inflation

Fixed-rate GICs may not keep up with inflation. The rate you agree to is locked in and often it’s relatively low, so if it’s a longer-term GIC and inflation climbs higher than your interest rate, you’re losing money in a way. For example, if inflation is 4 percent and your GIC has an interest return of 2.5 percent, inflation is beating your investment.

Variable-rate and equity-linked GICs may pay nothing

When you’re relying on markets to perform, you’re taking on more risk. Obviously if the markets don’t perform, then your GIC doesn’t perform either. The good thing about GICs is you get back your initial investment, regardless. But if the markets aren’t behaving, you’re also making no money.