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:
- The bank refuses to allow an early withdrawal
- 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 5||2.54%||2.35% (no penalty)||2.20% (no penalty)|
|year 10||3.00% (no penalty)||n/a||n/a|
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