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Long-Term CD Strategy Review with an Updated Comparison of Ally & Discover Bank

POSTED ON BY

With our current interest rate environment, there are only two ways to get a yield above 2.00% in a bank account. One is a high-yield reward checking account. The other is a long-term certificate of deposit. Even if you can meet the reward checking requirements, it's questionable if reward checking will continue to pay over 2.00% due to the Fed's mid-2013 pledge and the new debit card regulation.

For most banks and credit unions, you need a CD term of at least 3 years for a 2.00% APY. At Ally Bank, only the 5-year CD has a yield above 2.00%. As of 8/23/2011, Ally's 5-year CD APY is 2.20%. It's even harder to find a 3.00% APY. For that you need to a CD term over 5 years. Discover Bank continues to offer 3.00% APY on its 10-year CD. I have a feeling this won't last too much longer.

You might think a CD with terms of 5 or 10 years CD is way too long in today's environment with record low rates. Mid-2013 is only two years away. In 3 years we could be seeing much higher rates. Being stuck in a 10-year CD could be frustrating in an environment of rising interest rates. Of course there's also the other risk that rates will stay low for many years past 2013. That's the benefit of a CD ladder. In a CD ladder you just renew your long-term CDs into new long-term CDs at regular periods. You don't try to predict future interest rates. Some of you money may be stuck in long-term CDs when rates rise, but you'll also have some of your CDs maturing during that time.

The other thing to consider with long-term CDs is that you're not completely stuck in the CD until maturity. Most CDs allow an early withdrawal with a penalty. If the penalty is mild, closing a long-term CD early can be a good strategy when rates are rising.

As we have discussed many times in the last year, there are two risks if you plan to make use of an early withdrawal:

  1. The bank refuses to allow an early withdrawal
  2. The bank increases the early withdrawal penalty on your existing CD

Some banks include in their disclosures the right to refuse an early withdrawal request. For the second risk, it's not as clear. Many banks have blanket clauses in their disclosure which allows them to make changes to the account with at least 30 days written notice. If the bank should happen to make an account change (like increasing an early withdrawal penalty), you would have the opportunity to close the CD before this change takes effect with the existing early withdrawal penalty. The risk of banks doing this could increase if we move into a period of rapidly rising interest rates.

As I described in this post, one credit union has already increased an early withdrawal penalty on existing CDs. A complaint has been filed with the NCUA, and it's still under investigation.

I've looked into this issue at a few banks. For Ally Bank, I received assurances from Ally Bank's public relations director that Ally would not change the early withdrawal penalty on existing CDs (see post). Of course, this does not guarantee that Ally Bank won't make such a change. I'm currently looking into Discover Bank to see if they will give the same assurance as Ally Bank. I would like for the banks to update their disclosures to clearly say there will be no change to any of the CD terms (including the early withdrawal penalty) until the CD matures. However, I'm not optimistic about seeing such a change.

With these risks disclosed, I'll provide a new comparison of the long-term CDs of two banks which continue to offer competitive rates and mild early withdrawal penalties. The comparison doesn't only look at the yields if the CDs are kept to maturity, but also the yields if the CDs are closed early. This allows you to compare these long-term CDs to short-term CDs.

An easy example is a comparison of a 5-year CD and a 1-year CD. Assume the 5-year CD has a 6-month early withdrawal penalty, and assume that the 5-year CD is closed after 1 year. The 6-month penalty will result in the loss of half of the total interest of the CD. So the 5-year CD closed after 1 year results in an effective yield of half of the full 5-year APY.

Discover Bank vs. Ally Bank

I've updated my comparison of the long-term CDs of Discover Bank and Ally Bank below. I did my last comparison between these CDs in June when Ally Bank's 5-year CD was 14 basis points higher. Thus, Discover Bank's CDs are becoming better deals when compared to Ally Bank's CD.

Also note, I'm not taking into account the rate bonus for AAA members. Discover Bank still offers an extra 5 basis points on all CDs for AAA members.

Ally's Early withdrawal penalty is 60 days of interest for all terms. This is stated in Ally's account disclosure dated 6/18/2011. Discover Bank's early withdrawal penalty is described in its FAQ page and is as follows:

  • 3 months simple interest on the amount withdrawn for terms under 1 year
  • 6 months simple interest on the amount withdrawn for terms from 1 to 5 years
  • 9 months simple interest on the amount withdrawn for terms over 5 years

As can be seen in the table below, Discover Bank's 10-year CD has the advantage for early closures from 3 years and longer. Ally Bank still has the advantage for closures from 2 years and under. If you think it's unlikely we will see any rate hikes before 3 years, Discover Bank's 10-year CD would be the best choice.

As you can see in the table, the 2-year and 3-year effective yields are very competitive as compared to 2-year CD rates and 3-year CD rates.

The early withdrawal yields listed below are based on the spreadsheet developed by Bogleheads forum members. It's available from the Bogleheads Wiki: Comparing CDs. It should be noted that the following simple formula comes very close to this spreadsheet:

Post Penalty APY = (Full APY) x (D - P) / D

D = days into term when the CD was closed.
P = days of the early withdrawal penalty

These CD rates are based on the rates listed at the institutions' websites as of 8/23/2011:

Approximate Yields After Early Withdrawal Penalties

Year of Early Withdrawal Discover's 10-yr 3% CD Discover's 5-yr 2.35% CD Ally's 5-yr 2.20% CD
Early Withdrawal Penalty 9 months 6 months 2 months
year 1 0.74% 1.17% 1.83%
year 2 1.86% 1.76% 2.01%
year 3 2.24% 1.95% 2.08%
year 4 2.43% 2.05% 2.11%
year 5 2.54% 2.35% (no penalty) 2.20% (no penalty)
year 6 2.62% n/a n/a
year 7 2.67% n/a n/a
year 8 2.71% n/a n/a
year 9 2.75% n/a n/a
year 10 3.00% (no penalty) n/a n/a

Searching for Top CD Rates

To search for nationwide CD rates and CD rates in your state, please refer to the best CD rates section of DepositAccounts.com.


  Tags: Ally Bank, Discover Bank, CD rates, IRA rates

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Comments
6 Comments.


Comment #2 by Anonymous posted on
Anonymous
In a stagflation economy with low rates (which is looking more and more likely), it might be better to buy Series I Savings Bonds than any of these CD.  A higher rate than these CDs is guaranteed for I bonds going out to over one year, and the rate beyond that is determined by inflation.

Ken--I would be interested to see I Bonds discussed in these CD comparison posts, as they are now quite competative with the best CDs, although I realize that future rates for bonds can't be predicted beyond 6-12 months (plus they have the purchase limit of $10,000 per family member).

The choice seems to me to be this:  Buying CDs now is betting on a low-rate, low-inflation future, while buying I Bonds is betting on a low-rate, high-inflation future.  If rates shoot up, either one can be dumped (for a penalty, of course).  The risk with I bonds is that if future inflation is low or negative, and CD rates drop further and stay down for an extended period, than you've missed your chance for 3% yields.

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Comment #3 by KenBDG posted on
KenBDG
I have reviewed an estimate of the short-term returns of the latest I Bonds in this blog post. With current inflation, the real returns will likely be higher. We'll be able to provide exact return numbers in mid-October when September CPI numbers are released.

Unfortunately, there's no easy way to compare I Bonds with long-term CDs since the inflation component changes every 6 months. But if you assume inflation (as measured by CPI-U) will average at least 3.00%, I Bonds can be a better deal than current long-term CDs even before considering taxes. But as you mentioned, they are limited to $10K per year per SSN (and that may go down to $5K next year if paper I Bonds are purchased with tax refunds).

3
Comment #4 by Scott (anonymous) posted on
Scott
10K limit is the show stopper for I bonds. When you put the amounts into actual dollars it's peanuts and not worth the hassle of opening multiple accounts under different ss#. I can spend my time clipping coupons and save more money. If you just have $10k then it would be an ok option I suppose. I do like the Discover/Ally Bank Long Term CD strategy with early exit fees. I just can't bring myself to invest in stocks right now. I've lost so much over the years in IRAs and can never even write off the losses.  We cashed out our IRA & SEP's and paying off my mortgage and putting in CD/Savings accounts.  I'm guessing taxes will be (to pay our countries deficit) like pre-1980 rates by the time I retire. Which means double they are today and IRA 10% penalty doesn’t look so bad.  My prediction is there is going to be a lot of mad folks out there when they go to withdrawl non Roth IRA/401k's 15 years from now. Anyway, thanks for the  long term CD strategy.  I do have a REIT that earns 6%..it went public last year so have to worry about the stock price now...but like the quarterly dividend checks.  It's ticker is PDM.

 

3
Comment #5 by Anonymous posted on
Anonymous
valuable information

2
Comment #6 by Brian (anonymous) posted on
Brian
great information.. i hadn't considered using the penalties to my advantage should i need to close accounts earlier.. I'm just starting up a CD ladder, and I appreciate the information before I'm too far invested to change my plans.

1
Comment #7 by preferential treatment ? (anonymous) posted on
preferential treatment ?
but yet if i mention a symbol i get deleted really cashing out ira b4 59.5 how savvy  of an investment is that  i recall that you were already retired   whats the dealio

1