Are CDs Worthwhile Now?

POSTED ON MONDAY, FEBRUARY 27, 2006 BY Ken Tumin

With savings accounts paying up to 4.80% now and rates likely to increase at least for the next few months, should one consider a CD? At what rate and term would a CD make sense? The main disadvantage of a CD is locking your money for a specific time. One has to be willing to sacrifice liquidity for better rates. But with long-term rates so low, will you be better off with a high yield savings accounts even without considering liquidity?

Here's a quick rule of thumb to see if a certificate of deposit is worthwhile. Take the average of the current interest rate of your savings account and the predicted rate of the savings account when the CD would mature. If the current CD rate isn't above this, you would be better off keeping your money in the savings account.

The problem is that you have to take a guess what the savings account rate is going to be when the CD matures. For terms of over one year, this can be difficult. Refer to my chart comparing saving account rates with the Fed funds rate over the last year. You can see that the savings account rates have followed Fed funds rate fairly consistently. This website has the history of the Fed funds rate since 1990. It looks very likely that we'll see the Fed funds rate increase to 4.75% in the March 28th meeting, and it's starting to look more likely that the rate will increase to 5.00% in the Fed's May 10th meeting.

Here's an example of applying this CD rule of thumb:

Last April I opened a 11-month CD paying 3.75% APY. That may look like a mistake now, but compare this to what would have happened if I had kept the money in EmigrantDirect:


EmigrantDirect rate changes over the last 11 months:
April rate = 3.25%
July 20th  = 3.50%
Sept 20th  = 4.00%
Jan  26th  = 4.25%
Assume rate remains the same into March

The average APY can be computed as follows:
3 months at 3.25%
2 months at 3.50%
4 months at 4.00%
2 months at 4.25%
Average =   3.75%

So in this example, the 3.75% APY 11-month CD that started last April approximately equaled the money earned from an EmigrantDirect savings account. Also note that the actual EmigrantDirect average equals the average of the initial and ending APY (3.75%).

Future Example

So in the previous post, I noted a 5.50% 18-month CD from a credit union in Washington State. Is this term too long? First assume you don't care about liquidity. Next, try to estimate what the interest rates of savings accounts will be 18 months from now. I would take a guess at 6.00%. Assume you keep your money in HSBC's online savings account and the rate doesn't drop in May. Then the average rate by keeping your money in HSBC would be 5.40% over the next 18-months. So in this case a 5.50% 18-month CD may make you more money.

Comments

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2 Comments.

Finance Junkie | Feb 27, 2006 | Comment #1

It is also important to note the impact of a CD's early cash-out penalty when off-set by CD cash-out and reinvestment at higher rates. While a money market savings account yield may trend higher than an old CD, the possibility exists for early CD cash-out and reinvestment to get a net yield above what would otherwise be obtained with a MMSA alone. Of course, this strategy may involve more risk and time than some of us have.

Courtesy of: pluggedinfinance.blogspot.com

Anonymous | Feb 27, 2006 | Comment #2

If you like the security of a fixed rate such as a 30 yr fixed mortgage then CDs are the smart way to go especially long term ones variable market rate funds such as stocks savings accounts and arms are volatile

There are no tax cuts though if you want a safe long term investment with tax incentives, besides work 401/403, roth IRAs or even long term bonds the reintroduced 30 t-bill is also smart

for the safe seeking short term investor short term bonds are the way to go

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