Dedicated to Deposits: Deals, Data, and Discussion

Wisdom of Long-Term CDs in Today's Rate Environment?

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I've heard many people advise against buying long-term CDs in today's low-rate environment when there appears to be the possibility of much higher rates in the near future. This is reasonable, but it's important not to forget the risk that rates will stay low for two or more years. If rates do stay low, you'll miss out on higher rates that were available on the long-term CDs.

There is often too much concern over early withdrawal penalties. These penalties are not always too severe. For example, Pentagon Federal Credit Union is currently offering a 5-year CD with a 3.50% APY. The early withdrawal penalty is up to 6 months of interest. If rates start to spike a year from now and you want to break the CD, the result would be a loss of 6 out of the 12 months of interest that you had accrued in the CD. This makes the 1-year effective APY to be about half of 3.50% (1.75%). This isn't too bad when you consider this is higher than many 1-year CD rates from internet banks.

There is one risk when planning on an early withdrawals. Some banks have small print that gives them the right to refuse an early withdrwal request. Banks rarely make use of this right, but there have been cases where this has happened. I described some examples in this post on long-term CDs. If rates do shoot up, some banks may decide to enforce this right especially if they're having problems financially.

For Pentagon FCU, I can't find any small print in which they say they could refuse an early withdrawal. I have more details on PenFed CDs in this recent post.

OneWest Bank also has a fairly competitive 5-year CD with a 3.30% APY as of 1/20/2010. The penalty is 6 months of interest. Also like PenFed, I can't find any small print in OneWest's disclosure that gives them the right to refuse an early withdrawal. Refer to my OneWest CD review for more details.

  Tags: CD rates, Pentagon Federal Credit Union, OneWest Bank

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Comments
25 comments.
Comment #1 by Mary (anonymous) posted on
Mary
Perfect title – Wisdom, and very useful anaylsis.  Rates can go lower, rates can wander in the same range, and rates can increase.   In the current low rate environment a longer term bank or credit union certificate, purchased directly and with a reasonable early penalty withdrawal, provides less interest rate risk than a brokered certificate.  If interest rates rise, simply do the calculations to determine if you should pay the penalty and reinvest at a higher rate.  Also, usually, you can withdrawal the interest earned from a certificate, at any time, without a penalty and reinvest those funds in a new certificate. 

An additional factor to calculate is to make an assumption about when you think interest rates might rise, and by how much.  Then use a CD calculator to see by how much and when future long term rates; combined with current short rates; have to rise to equal current five year rates.

It is useful, also, to have access to both direct purchase certificates and brokered certificates.  Brokered certificates occasionally offer a small premium and the possibility for capital gains in a falling interest rate environment.

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Comment #3 by john (anonymous) posted on
john
The banks can change the terms of withdrawals after the CDs are issued.

If too many people start to pull the money out, they can refuse any further withdrawals.

FDIC can intervene and block any pull outs.

The banks are not puting the ban on CDs withrawals for the simple reason that they have right to refuse any pull outs.

Since you don't see it in the disclosure, means that they reserve the right to insert it at will at any time.

So don't get to complaisant about what is in the disclosure, they can negate anything in it.

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Comment #5 by snipeman posted on
snipeman
I feel the frustration of everyone telling me not to buy long term CDs or bonds, then having no viable suggestion of where to put my money.  Some people are actually trying to live off their money now, not later.
  
I just bought a 4 year Penfed CD at 3.25% a few weeks ago.   I think this is a good compromise for the moment.   The CD can be broken for 6 months of interest.   If the pundits are right and interest rates go up 18 to 24 months from now, I still don't see how I can do any worse than getting 1 to 2% now.

Of course I am not allocating all of my money at longer terms.  I have a CD ladder that mostly matures 2 years from now.  Sadly most of those CDs are paying over 6%.

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Comment #7 by xxyy (anonymous) posted on
xxyy
I think the concept of brokered CDs and premiums needs some clarification.

After you buy a brokered CD, it can be sold on a secondary market just like stocks and bonds, but not redeemed at the bank before maturity.  In the event that interest rates should drop even further than today's levels, the value of a brokered CD could conceivably rise above the face value (plus accrued interest) of the CD on the secondary market, just like bond values rise when interest rates drop.  The converse is also true, if interest rates rise, the value of CDs on the secondary market can drop below face value.

Interest earned on a CD is never a capital gain.  But if you manage to sell a CD for more than you paid for it, the difference is a capital gain.  (And if you sell it for less than you paid, the difference is a capital loss.)  If the interest is reinvested in the CD, the calculation to separate out how much of the change in value is due to accrued interest and how much is due to a change in value of the underlying CD (the capital gain portion) can be a little complex.

Unfortunately, the secondary market for brokered CDs is rather opaque, controlled by just a few big players.  Trades are usually in blocks of millions.  Small-time investors usually get eaten alive by the bid-ask spreads and commissions.  Rates would have to drop dramatically to enable you to sell your $10k or $100k CD at a gain.

On the other hand, rather than just looking at the list of new-issue CDs your online broker has on their web site at face value (par), when you want to buy a brokered CD, you might want to contact a broker who can search deals on the secondary market and find you a cheaper CD than one directly issued by the bank.

And just to clarify, if you wait until maturity, the issuing bank will redeem your CD for face value plus accrued interest.  But if you want to get rid of it early, you are faced with selling it on the secondary market where you could have a capital gain or loss on it.

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Comment #8 by Anonymouse (anonymous) posted on
Anonymouse
.

 

>> After you buy a brokered CD, it can be sold

>> on a secondary market just like stocks and

>> bonds, but not redeemed at the bank before maturity.

 

True ... However the important thing here is that most brokers allow you to buy new issues at face value, but when you try to sell on secondary, they will charge a comission that is typically $20-$30.  Therefore the rate difference needs to be high enough not only to justfy the sell, but also to overcome the commission. 

Oh ... and after the sell the natural question is "what next"?  Where are you going to place the proceeds?

 

 

>> On the other hand, rather than just looking at

>> the list of new-issue CDs your online broker has

>> on their web site at face value (par), when you

>> want to buy a brokered CD, you might want to

>> contact a broker who can search deals on the

>> secondary market and find you a cheaper CD

>> than one directly issued by the bank.

 

Indeed ... this is a sound way to make some additional money.  However ... once again one needs to overcome the broker commission. 

Let me know which brokers are willing to do this? If the commission is reasonable, then maybe I'll look into them.

I tend to buy only the new issues traditional, variable, stepped and index-linked all at face value with no commission.

.

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Comment #9 by Jim DAvis (anonymous) posted on
Jim DAvis
 Another gotya rarely mentioned.

 

 Most brokered cd's bought in the after market these days are sold at a PREMIUM to 100 cents on the dollar.  That premium is NOT covered by FDIC.

 

Got it? If the bank fails, you will LOSE that 2 or 3 or 4 percent extra you paid for the CD with a high coupon.

 Evne with that being the case, most secondary CD's sold on Etrade for instance are paying pitiful net rates of interest. I don't know exactly why, but the are pretty useless as investments these days.

 

 



 

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Comment #10 by Brad (anonymous) posted on
Brad
Great discussion.

Another way to invest is to buy a ladder of CDs. An example:

You have $5,000 to invest today. You could split it among five CDs, $1,000 each; CDs coming due in 12 months, 24 months, 36 months, 48 months, 60 months.

One year from now, you could roll that maturing 12-month CD into a new five-year CD. And so one.

So over time, you would have a continually renewing collection of five-year CDs. If interest rates do go up over the next few years, you would get the advantage of those higher rates as you roll into new CDs.

Skittish about investing for five years? Well, you could create a three-year ladder, putting splitting your $5,000 into one-year, two-year and three-year CDs; then rolling each into a new three-year CD when a CD matures.

At any given time, long-term CDs should pay better than short-term CDs, so a ladder over time gives you the advantage of higher rates.





 

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Comment #11 by Anonymouse (anonymous) posted on
Anonymouse
.

 

>> At any given time, long-term CDs should

>> pay better than short-term CDs

 

Indeed ... most of the times that's true. 

However there are times when long-term CDs actually pay less than short-term CDs.  Such times are rare, but they do happen. Often times they are seen when the yield-curve is inverted.

 

 

>> so a ladder over time gives

>> you the advantage of higher rates.

 

Err ... maybe.

The ladder generally gies the advantage of higher rates as well as the dis-advantages of lower-rates because by defnition of the ladder, you are accepting the mix of long and short terms.  Therefore, the ladder generally will give you an average.

 



.

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Comment #12 by Brad (anonymous) posted on
Brad
Interesting points there. If one buys the hypothesis that interest rates likely will rise at some point over the next few years, anyone have an opinion on the optimal length of a CD ladder that would allow one to take advantage of rising rates?

For example, if I <knew> interest rates would start rising in January 2012, then it would seem rational to do a ladder today of 6-month, 12-month, 18-month and 24-month CDs, rolling each into a new 24-month as it matures, to position myself for rising rates.

So again: Given where we are now, what would be the rational, optimal ladder for someone who wanted to build a CD ladder starting today?



 

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Comment #13 by Anonymouse (anonymous) posted on
Anonymouse
.

 

>> For example, if I <knew> interest rates would

>> start rising in January 2012, then it would seem

>> rational to do a ladder today of 6-month, 12-month,

>> 18-month and 24-month CDs, rolling each into a

>> new 24-month as it matures, to position myself for rising rates.

 

Nope ... it won't be.

If you knew that rates will start rising in Jan 2012, then it would be rational to buy just 1 CD with highest rate you can find, that will mature in Jan 2012. That way you have positioned your funds to become available when the rates will start rising and until then you have locked them at the highest rate available today.

One of the reasons lots of folks make a ladder is because they don't know when the rates will rise (and fall), therefore they mix different terms/rates and in effect average it out. (Another reason of course is that the funds will become available at regular interevals should they be needed.)  The ladder is lot like going with an index fund like S&P 500 based fund.  Such an index fund won't give you spectacular gains, but you are assured of getting the average return.

 

.

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Comment #14 by Investor_Saver posted on
Investor_Saver
I see a lot of mis-information regarding Brokered CD's

You can buy as little as $1,000 on the secondary market, you dont have to buy "blocks of millions" as one person posted.

New Brokered CD's usually require a $5,000 minimum. Your broker may have $10-$25,000 listed as the minimum if you look online. Just call your brokers fixed income desk, and tell the broker you want $5,000 I have never had a broker tell me no.

When you buy CD's your broker should not charge any commission. If they do, change brokers or ask them to waive the fee as most other brokers are doing.

 

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Comment #15 by Anonymouse (anonymous) posted on
Anonymouse
.

 

>> You can buy as little as $1,000 on the secondary market

True.

 

>> New Brokered CD's usually require a $5,000 minimum.

Not necessarily ... New issue CDs can be purchased in increments of $1,000 at Fidelity and Schwab.

 

>> When you buy CD's your broker should not charge any commission.

Again ... not necessarily ...  Most brokers I guess will waive commission only for buy orders of new issues, but for buy orders on secondary most brokers I guess will charge the commission.

 

.

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Comment #18 by handicappers (anonymous) posted on
handicappers
intresting points here...

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Comment #19 by Anonymous posted on
Anonymous
GBJS.......

Ones of the rules that Banking Guy made to post on this site, is to speak English !

Thanks

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Comment #20 by Wendy Clark (anonymous) posted on
Wendy Clark
Ken,
I work for Ally and thought I would share some information that I think your readers may find helpful.  We have just added a new option to our 24 month high yield CD to help customers with this concern.  The 24 month CD which has a rate of 2.15% (as of 28JAN10) gives customers the opportunity to raise their rate one time if Ally’s 24 month CD rates increase.   Also, our penalty for early withdrawals for all our CDs is only 2 months. This gives customers peace of mind knowing that if rates do increase, they can take advantage of a higher rate while also avoiding early withdrawal fees if a customer needs access to funds.   
 
Wendy Clark
Social Marketing Manager
Ally Bank/GMAC

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