Thursday, March 23, 2017

CD Basics

The perfect CD is government insured, has a high interest rate, and is easy to cash and to change interest rates. If you get the first requirement, you cannot get the other requirements. They are found on the stock market were you average out returns over 10 or more years and expect that average value to grow about 10% a year.

Capital One 360 is now offering an FDIC insured 5-year term CD for 2% per year. I am using this and the discounted values (1.8%, 1.6%, 1.45% and 1.3%) for shorter term CDs in this post.

I have found four ways to manipulate CDs beyond investing $10,000 in one 5-year term CD ($10,000 * 2% * 5 year = $1,041 with compound interest). [Provision Living at Columbia credited our bill for the two months we were refugees.] 

Divide the pot into five $2,000 CDs, which can be manipulated in several comparable ways. The table shows how to build a ladder up from low to high rates. Replace these rates for the other ways to manipulate CDs. For example, delete the values for reinvesting (CDs 6-9) and the table turns into a savings mode.

1.    Building up a ladder of CDs that mature at different dates using different terms. In this case, five CDs ranging from one year to five years. The rate of return increases with the increased term from 1.3% to 2%.

This is touted on the Internet as a way of increasing our earnings. In a normal market, it does average out the earnings. This yields $959 or costs $82 ($1,041 - $959 = $82 or 8%) to build the ladder over a period of five years.

The usual example replaces matured CDs with the maximum rate (2% for 5-year CDs). The build is slow and the adjustment of the resulting 5-year term to current markets is also slow (which is good when interest rates fall as they did in the past decade). Interest rates are now at an historic low. Expectations are from continuing low rates to increased CD rates.

2.    Building down a ladder of CDs from the maximum rates by cashing one each year and buying a new one. That would cost $172 ($1,041 - $869 = $172 or 17% (a current credit card rate) in this example given no change in interest rates.

3.    Maintaining the range of rates (replacing each maturing CD with the same term) in the ladder would cost an estimated $199 or 19% over the five years and about $40/year (2%) thereafter.
4.    Treating the funds as a saving account with the expectation of removing 1/5 of the pot each year.

Interest on $10,000 over Five Years
Savings with Withdrawal

  Build Up (Selecting Rates)
$535 (zero balance)
  Build Down (From Maximum Rate)
$447 (zero balance)
Fractional (Cashing Each CD With a
One Year Penalty)

  One CD Cashed during 1–5 Years
$825-$954 ($8,000+ bal)
  Second CD
$615-$741 ($6,000+ bal)
  Third CD
$406-$531 ($4,000+ bal)
One 5-year $10,000 CD


Fractional investment yields the same thing as a single CD ($1,041) if no funds are withdrawn. Withdrawing funds turns the account into savings that far exceed up built laddering when used as savings; until you cash the last two CDs when the overall cost is again $200 to have maximum anytime access to the remaining funds instead of waiting for CDs to mature as in the above option.. Borrowing from one's self (less than 2%) is less expensive than using a credit card (16%).

Laddering makes sense in a calm market. The finer the total pot is fractionated, the more control you have in managing interest rates. if they do go up and fast enough to make a difference. As each long term (5-year) CD matures you have the option to cash or to reinvest with no penalty for that CD. The remaining CDs will be slow to adjust to any rapid change in interest rates.

You can manage interest rates by limiting the term of each CD or by buying the maximum return for the day and cashing in for a higher rate later. But when do you cash in an immature CD to take advantage of a higher interest rate? Does it make sense to buy short term, low rate, CDs that at maturity are replaced with long term higher rates; that are then again slow to respond to rapid changes in interest rates? What seems like a solution, short term, looks like it just recreates the original problem in the long term in un-calm markets.

Is this something to be concerned about given our short five-ten year horizon in which our cash flow far exceeds our finances? We will then be 90 and 97, which is highly unlikely. I still feel we need to adjust to going broke gracefully while currently enjoying a best buy in memory care for the two of us. Our two month stay in assisted nursing at South Hampton Place gave us a preview.

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