Ally Bank's Raise Your Rate CD vs. the 5-Year CD

Ally Bank has started a new commercial for its Raise Your Rate CD. It's a funny commercial, but should you really love your Raise Your Rate CD? How does it compare to Ally's 5-year CD which has a very mild early withdrawal penalty of only 60 days of interest?

The Raise Your Rate CD has a 2-year term, and it gives the customer one option to raise the rate to the existing 2-year CD rate any time during the term. No change is made to the CD maturity date. This CD may look appealing when rates are so low.

If rates do go up substantially, the Raise Your Rate CD might seem that it would be a better deal than the 5-year CD. One complication is that the customer only has one option to increase the rate. So if rates start rising, the customer will need to decide if he should request the rate bump or wait for higher rates. If he waits too long when there's not much time left until maturity, the rate bump won't help much to raise the customer's overall CD return.

For simplicity in the comparison, I'll assume the following possibilities:

1. Rate doesn't increase
2. Rate is 1 percentage point higher after 1 year
3. Rate is 2 percentage points higher after 1 year

In my opinion these higher rate assumptions are optimistic. With the talk of a new round of Quantitative Easing by the Fed, it may take much longer for us to see rate hikes of this size.

The Raise Your Rate yield as of 10/04/2010 is 1.71% APY. With this initial yield, the above cases result in the following average approximate yields:

1. 1.71% APY for 2 years
2. 2.21% APY for 2 years (1.71% for 1st year, 2.71% for 2nd year)
3. 2.71% APY for 2 years (1.71% for 1st year, 3.71% for 2nd year)

The 5-year CD yield as of 10/04/2010 is 2.64% APY. To compare the above cases with a 5-year CD, the following two options for the 5-year CD should be considered:

1. Early withdrawal after 2 years - If the customer decides to make an early withdrawal at year 2, the approximate average yield for those 2 years would be 2.42% APY. That beats the Raise Your Rate CD rates for cases 1 and 2 above.
2. Early withdrawal after 1 year, re-invest in a new 5-year CD, and make an early withdrawal 1 year into second CD - If rates do shoot up by 2 percentage points after 1 year, the Raise Your Rate CD would have an advantage over just keeping the 5-year CD for 2 years. However, the customer can do an early closure of the 5-year CD after the first year. That money could then be re-invested in another 5-year CD which would likely have a rate that is also 2% higher. If the customer chose that path, and did another early withdrawal after another year, the 2nd year yield would be 3.88%. Averaging that with a first year yield of 2.21% results in an average 2-year yield of about 3.05% APY.

Even if rates do shoot up, Ally's 5-year CD would very likely beat out the 2-year Raise Your Rate CD. In addition, the 5-year CD has an extra advantage of protecting against the case of rates going lower or staying low.

Please refer to my Ally Bank CD review for more details. Some have been worried about the chance that Ally could increase the early withdrawal penalty. There should be no risk of this for existing CDs (see post).