Deciding Between Short-Term and Long-Term CDs

This CNNMoney article reminded me of an issue that many savers are facing. Bond yields continue to be very low, but there appears to be a lot of reasons why yields should soon be surging. Higher yields could result from strong economic improvement or if there are more concerns that the federal budget deficit will get further out of hand. As we learned in the last few years, it's very hard to know when we will see changes. The best example was what happened in 2011. Bill Gross who manages the world's largest bond fund guessed wrong in early 2011 when he was sure bond yields would rise before the end of 2011.

If you're a bond investor with long-term bonds, those bond prices could plummet if yields spike. Thus, you might lose a lot of your principal if you need to sell those bonds.

Savers with long-term CDs that were purchased directly from banks and credit unions don't have this exact problem. These CD holders don't have to worry about the value of their CDs if rates shoot up. However, they may still want to dump their low-yield CDs for new bank accounts that pay higher yields.

The cost of dumping a CD is the early withdrawal penalty. There are concerns about early withdrawals in an environment where interest rates are spiking. Will institutions refuse early withdrawal requests? Will they honor the original early withdrawal penalty? We have discussed these risks many times. Since there have been cases in which institutions have increased the early withdrawal penalty on existing CDs, there are legitimate concerns.

In my post on banks that give certainty about CD early withdrawals, DA reader ChrisCD provided a useful suggestion in his comment:

The biggest tip I can provide is keep abreast of rates and close your CDs early when the timing is right. I think the first "wave" of closures will probably go without a hitch. But as the banks receive more and more requests, more attention could be given, and potential refusals.

If institutions change their disclosures, regulations do require them to provide at least 30 days notice before those changes take effect. So if you keep abreast of both interest rates and your CDs, you should have a good chance at getting out of the CDs without an unexpected cost.

Also, it's a good idea not to put all of your eggs in one basket (another ChrisCD tip). Holding CDs at several institutions can reduce this risk. For example, in my opinion, it's unlikely that we will see several different institutions acting together to block CD redemptions or raise early withdrawal penalties on existing CDs.

Another example of not putting all your eggs in one basket is to not put all of your money into long-term CDs that all mature many years from now. This can be done with a CD ladder in which you will always have some of your CDs maturing in regular periods. It's a strategy that can allow you take advantage of the higher yields of long-term CDs without locking all of your money for a long period of time, and you don't have to worry about early withdrawals to take advantage of future higher rates.

Another way to get higher yields now without the risk of losing out on future rising rates is with Ally Bank's 4-year Raise Your Rate CD. If interest rates rise, you don't have to worry about an early withdrawal to take advantage of the higher rates. Ally Bank gives customers two chances to increase the CD rate to the current rate of the 4-year Raise Your Rate CD. One downside of this is that the rate of the 4-year RYR CD is a little low compared to the best 5-year CD rates (1.45% APY as of 5/3/2012). Another potential downside is that the RYR CD rate may not stay competitive in the future. If that happens, it won't be beneficial to use those rate bump options. Please refer to my Ally Bank Raise Your Rate review for more details.

No investment is without risk. CD holders who stay below deposit insurance limits don't have to worry about losing principal, but they still have to worry about losing out to inflation. If inflation rises substantially, interest rates may also rise. So savers will want to quickly take advantage of those higher rates to help offset inflation. As you can see, there are many issues to consider when deciding on CD maturities, the types of CDs and the institutions offering the CDs.