My previous post, CD Basics, explored the use of CDs as savings and as an investment in a stable normal financial market. Buy a CD to save for an expected expense that occurs well after the maturity date.
The length of the cashing penalty is a good guess if in doubt. Rather than having to cash a 3-year CD at two years with a six-month penalty (1.5 year term), buy a 2-year CD that matures.
But interest rates are now poised to remain stable or increase more than decrease. What increase is needed to justify cashing a CD with penalty to buy a new one at a higher interest rate?
|Interest Rate Factors|
A CD paying 2% interest (our current top rate for a 5-year term) with a 1-year penalty would have to be reinvested in a 4-year CD paying 3% (2% * 1.50 = 3.0% per year) or another 5-year CD paying 2.4% (2% * 1.20 = 2.4% per year) just to break even. We would not be paid any interest for five or six years. That is the simple interest story (rate x time); nice straight lines when in a graph.
|Interest Rates and Payouts|
“A rising tide lifts all boats.” True and false. The company gives everyone an equal raise of 5%. Some pay checks show an increase for the year of $500; others show $50,000.
The same is true for interest rates on CDs. The higher the interest rate you start with (red), the higher the earned interest with an increase in rate.
The chart shows the result of the same an annual 24% increase in the interest rate (from 2% to 5% in five years) applied to CDs with different terms. The 5-year term CD grows faster than the 3-year CD. The actual payout percentage is also different.
The 5-year term CD starts with a higher interest rate than the 3-year term CD. At three years, the 3-year CD matures and is reinvested at an even higher rate. At five years, the 5-year CD matures to be reinvested at an even higher rate, assuming an increase in interest rates from 2% to 5% over the five years.
If you needed the money after three years, a 3-year CD would payout and/or would be ready to be reinvested at a higher rate. If you would not need to use the money, a 5-year CD would win out in the long run.
You save for short term needs at the current interest rate with no penalties. The sooner you invest, and the more you invest, the higher the payout with compound interest, with no penalties; unless interest rates rise enough and fast enough. My Mom mentioned only one error she made: not cashing her 8% CDs and buying 5-year 18% CDs.
You get the chance to reinvest sooner with short term CDs, BUT you pay for this privilege by accepting lower starting interest rates. The lag in CD payouts, with respect to the compounded interest rate, results in an efficiency of 79% for 3-year and 72% for 5-year CDs, in this example.
The lag [21% and 29% for 3-year and 5-year CDs, the area between payout (solid) and compounded interest (dashed) lines] gets worse the longer and faster interest rates increase. This is the money you potentially lose if you do not cash and reinvest (7% and 6% per year); before also considering the penalty of 1/6 of a 3-year term (16.7%) and 1/5 of a 5-year term (20.0%) of the interest for each CD reinvestment, when chasing interest rates.
The penalty, in this example (interest rates increase from 2% to 5% in five years), is less than the lag one wants to close. With less of an increase in interest rates, they could be the same or less. Short term security has a cost.
These gains and loses can be obtained daily on the stock market, if you buy or sell the stock or bond; over time, they balance out. But there is no short term guarantee of returns or insurance. Time and indexed funds (Warren Buffett’s ten year challenge to hedge fund managers) are your guarantee in the stock market.
Cashing and reinvesting sounds good, but if I am right on this, it only pays off if you guess right and interest rates rise fast enough. The result may be nothing more than the original payout with a delay of one year for each recycling.
I see holding money in cash, with no interest, until the “right” time a poorer option than investing in a long term CD with the potential of losing just one year of interest when the “right” time arrives. The “right” time may never come.
My Mom’s advice was invest, forget about, and live a long time. That was when banks were secretive and intimidating. The Internet and truth in advertizing laws have swept that away. Small banks pay better than large banks, in general. They are all FDIC insured.