Wednesday, March 29, 2017

CD Term Versus CD Fraction

Selecting the term of a CD (and as a consequence, selecting the interest rate) makes sense when saving for well-defined needs.  Selecting CDs by their interest rate, by other than the highest yield offered, in my opinion, is gambling with the protection of FDIC insurance.

The entire pot can be managed in another way: dividing the pot into fractions. Then cashing a fraction when the need arises. This is a common savings practice. Is it a good investment practice?

The table combines CD term (and thus interest rate) and penalty, for the year a fraction is cashed, after dividing the pot into one to ten fractions. Cashing a 5-year CD at the end of the first year is not a good investment practice: no interest is paid.

Cashing one of two 5-year CDs cuts the cost (or loss) in half. Three fractions bring the cost down below that of cashing a 1-year CD before maturity.
Comparative Yield

I find it interesting that the cost of cashing immature 1-year CDs levels out after dividing the pot into three factions. The cost of cashing immature 3-year CDs levels out after five fractions. A 5-year CD earns the most, costs the least, after just three fractions.
Comparative Cost

CDs are then designed for secure savings. They work best when held to maturity. They pay less than stocks and bonds.

Rising interest rates can be chased with cash, short term CDs that mature, and long term CDs that are cashed when immature. Do these work better than investing in an indexed fund that averages gains and losses and can be accessed at any time?

The overall answer, a year ago, was an annuity from our house sale that pays a fixed amount each month for ten years (it has been a good deal for year one).

Cash                            The total loss of interest (a 100% cost).

Short term CD            The discounted rate of interest from the 5-year CD (a 35% to 20% cost, in my example, for a matured 1-year and a 3-year CD).

Long term CD            The penalty on a single immature 5-Year CD (year one, 100%; and down to a cost of 20% thereafter on a 5-year CD).

CD Fraction                The cost of cashing an immature 1/5 pot fraction 5-year CD is 20%; which then yields the same rate (80%) that a matured 3-year CD is discounted to from a matured 5-year CD interest rate.

Indexed Fund              A variable cost that is not assessed an average 20% charge, as I have found for the above CDs. A drop in the market of 20% is highly unlikely (approximately what happens when you do not pay your credit card bill in full each month). The rate of return from the fund follows the market up and down.

Annuity                      The ten year contract we bought fixes the rate of return at the average low market value in 2016. It has a potential cost related to any marked increase in interest rates.

In summary, fixed rate CDs will always lag the market. This is very good when interest rates fall as they did in the past decade for economic and political reasons. The lag with rising interest rates, if it happens fast enough, will cost. That cost seems to be small (with a 2% CD interest rate) in relation to the about 20% difference between CDs and an indexed fund even on a stable year.

So, my best judgment is, buy maturing CDs to insure funds needed during the next three or so years. Buy long term CDs with the option of cashing a fraction of the pot before maturity for unexpected needs. 

Buying an annuity to insure funds for the next ten years is now questionable, unless there is a compelling situation (memory care). Learn about indexed funds and how they work today on the Internet for the $10,000 we have in hand from the flood at Provision Living at Columbia.

We can eat in the main dining hall tonight for the first time in three months!

No comments:

Post a Comment