With short-term rates being so low, long-term CD rates are tempting. Even long-term CD rates are not great, but they can be 2x and 3x the levels of short-term rates. The worry is that rates will eventually rise, and when they start to rise, they could shoot up.
If things continue as they have in the last two years, a sharp rise in interest rates doesn't seem likely. However, things can change quickly when there's a crisis, and there's concern that a crisis from a failure to raise the debt ceiling could be one that causes big hikes in interest rates.
There's also a risk that the interest rate environment that we've seen in the last 30 months will continue for several years.
No one knows when interest rates will rise or by how much they will rise. This is one reason for CD ladders. You don't have to guess when to invest in long-term CDs. You just invest a portion of your savings in the longest term in regular intervals of time. It gives you some protection if rates stay low and also if rates start to rise.
The early withdrawal provisions of CDs can reduce the risks of being stuck in a low-rate long-term CD if rates shoot up. However, there is a concern that in such an environment, banks and credit unions will make it more difficult for customers to make early withdrawals. One way could be to refuse an early withdrawal request. Another way is to increase the penalty for early withdrawal on existing CDs. Either possibility increases the risk of being stuck in the low-rate CD and missing out on much higher CD rates.
I've covered one case in which a credit union raised an early withdrawal penalty on existing CDs. I'm still waiting on the NCUA ruling on this. The NCUA Consumer Compliance Analyst has been investigating this issue, and I was told they are in the final review process.
Long-Term CDs from Ally Bank and iGObanking.com
There are currently two noteworthy banks that have competitive long-term CD rates and reasonable early withdrawal penalties.
We have long known about Ally Bank's very mild early withdrawal penalty of 60 days of interest. Even though Ally's 5-year CD has never had the best rates, this small early withdrawal penalty makes this CD a good deal (and now Ally Bank has IRA CDs).
Many have been concerned if this small penalty will hold on existing CDs. Last year I investigated this, and received assurance from Ally Bank's public relations director that Ally would not change the early withdrawal penalty on existing CDs (see post). Of course, this doesn't eliminate the risk.
iGObanking.com has joined Ally Bank in this issue after they launched their new 7-year and 10-year CDs with very competitive rates (see post). iGObanking.com's early withdrawal penalty is larger than Ally's, but it's mild for 7-year and 10-year CD terms. The CD details are described in the bank's disclosure page. According to this disclosure:
If your account has an original maturity of one year or greater: The fee we may impose will equal six months simple interest on the amount withdrawn subject to penalty.
This 6-month interest penalty is mild. Most 7-year and 10-year CDs have EWPs of at least 1 year of interest.
As I pointed out last week, iGObanking.com had a disturbing sentence in their disclosure regarding early withdrawals:
You may make withdrawals of principal from your account before maturity only if we agree at the time you request the withdrawal.
So this could keep you stuck in a low-rate CD if rates shoot up.
One interesting thing happened in the last week. iGObanking.com removed this sentence from their online disclosure.
That removal is definitely nice to see. But does the disclosure still have clauses that may restrict our ability to make an early withdrawal? One reader found the following two clauses in the disclosure:
Withdrawals from a time account prior to maturity or prior to any notice may be restricted and may be subject to penalty. See your notice of penalty for early withdrawal.
We may change any term of this Agreement. Rules governing changes in interest rates are provided separately. For other changes, we will give you reasonable notice in writing or by any other method permitted by law. We may also close this account at any time upon reasonable notice to you and tender the account balance to you by mail.
In addition to restricting early withdrawals, it appears the last clause could be used by the bank to close a CD early before maturity. Last year I reported on one bank that did this. This would not be an issue in a rising rate environment, but it would be an issue if rates continue to fall.
Comparing Ally Bank's CD with iGObanking.com CDs
As you can see, the strategy of depending on early withdrawals of long-term CDs does have some risks. I can't say how big these risks are. Nevertheless, if you understand the risks, this strategy is something to consider.
To help you make the trade-off analysis, I did another early withdrawal yield table. I compared iGObanking.com's 7-year and 10-year CDs with Ally's 5-year CD. I listed the effective yields when the CDs are closed early for each year after account opening. The yields take into account the early withdrawal penalties. As you can see, Ally Bank's 5-year CD only has the best rate at year 1. After the first year iGObanking.com's 10-year CD takes the lead.
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 7/11/2011:
Approximate Yields After Early Withdrawal Penalties
|Year of Early Withdrawal||iGObanking's 10-yr 3.5% CD||iGObanking's 7-yr 3.1% CD||Ally's 5-yr 2.33% CD|
|Early Withdrawal Penalty||6 months||6 months||2 months|
|year 5||3.14%||2.79%||2.33% (no penalty)|
|year 7||3.25%||3.10% (no penalty)||n/a|
|year 10||3.50% (no penalty)||n/a||n/a|
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