As online banks cut their deposit rates, an interesting phenomenon has occurred. Many online banks now have higher interest rates on their savings accounts than their 5-year CD rates. We typically expect long-term CDs to offer the highest rates since you’re locking in your money for the longest period of time. That’s not the case today as banks transition their deposit rates in this new zero interest rate environment.
Here’s a snapshot of the rates at a few online banks with these inverted rates. APYs are accurate as of 5/18/2020:
American Express NB
Savings Account APY
5-Year CD APY
For Treasurys, it’s called an inverted yield curve when short-dated Treasury yields are higher than long-dated yields. Parts of the Treasury yield curve were inverted many times last year. Recessions often follow inverted yield curves. The lower yields on the long-dated Treasuries often signal market concern for the economic outlook.
When banks set their long-term CD rates lower than their savings account rates, it’s a sign that banks are anticipating lower rates in the future. It’s also a sign that banks will probably be cutting their savings account rates. Since it’s easy for savings account customers to move money from online savings accounts, competition and the need for deposits may deter online banks from quickly cutting their savings account rates. So this inverted yield condition will likely end as online banks slowly lower their savings account rates.
You expect to be rewarded with higher interest rates in CDs than in savings accounts, and you expect to be rewarded more on longer-term CDs. That higher interest rate offsets having to lose access to your money for a longer period of time. Until the CD reaches maturity, you can only access the principal of the CD with an early withdrawal penalty (for most cases). You can withdraw money from savings accounts without any significant restrictions.
For depositors, CDs have one big advantage over savings accounts. That advantage is a rate lock. When rates are falling, the guaranteed interest rate for a period of time can be an advantage. The opposite is true for banks, which may consider the rate lock detrimental. If the bank’s old CDs have interest rates much higher than the current rates, it’s costly for the banks.
When does a 5-year CD rate become too low?
This is a difficult question for a CD investor, especially one who uses CD ladders.
Consider how low online savings account rates may fall
One important factor to consider is what the bottom may be for the online savings accounts. During the last zero rate period from 2008 to 2015, you could still get online savings accounts with rates near 1.00%. For example, Ally Bank’s savings account bottomed out at 0.84%, Discover Bank bottomed out at 0.80%, and American Express bottomed out at 0.75%.
If we assume this new zero rate period won’t be worse than the last, 5-year CDs with rates near or below 1.00% don’t make sense. However, in the last 20 years, every recession seems to be followed by ever lower deposit rates. So it is possible we may see lower bottoms on online savings accounts. If we have to live with 0.25% rates on online savings accounts for several years in the future, locking into a 1% rate for five years may not be as crazy as it sounds.
Consider CD early withdrawal penalties
Another factor to consider is the CD early withdrawal penalty (EWP). A low-rate on a long-term can be more acceptable when the EWP is smaller. Even if the CD rate is lower than the current savings account rate, you may end up earning more interest in the CD after a few years even if you close the CD early. That becomes more likely if the EWP isn’t too big.
As an example, let’s say you open a Barclays 5-year CD today which has a 1.20% APY and an EWP of 180 days of interest. If you close that CD in three years, the effective annual yield for those three years after you factor in the penalty will be about 1.00%. If the highest savings account rate by next year is only 0.75%, the Barclays 5-year CD would have actually been the better deal.
On the other hand, it’s difficult to see how the 5-year CD at American Express National Bank would be a better deal than keeping your money in online savings accounts. If you open a American Express 5-year CD today which has a 1.10% APY and a large EWP of 540 days of interest, any early closure will be costly. For example, if you close the CD after three years, the effective annual yield for those three years after you factor in the penalty will be about 0.56%. I consider it unlikely that online savings account rates will fall enough for this 5-year CD to be the better deal.
To review the effective yields of these two CDs closed early, please check out our CD Early Withdrawal Penalty Calculator. Also, when factoring in CD early withdrawals, be aware there is some small risk that a bank or credit union may increase EWPs on existing CDs. There have been cases when credit unions have increased EWPs on existing CDs. Also, there’s a small risk that a bank or credit union may disallow an early withdrawal request. In that case, you would be completely locked out of accessing any principal of your CD until maturity. The odds are higher at banks and credit unions that have disclosures that give them the right to make such changes. I reviewed these types of CD disclosures a few years ago.
Don't settle for these low 5-year CD rates
Fortunately, we don’t have to settle for 5-year CDs listed above. There are still online banks that are offering much higher rates, and there are several credit unions that are offering even higher rates. However, the top CD rates continue to fall, and it’s now difficult to find 5-year CD rates above 2%.
Is a 2% 5-year CD too low for you? What’s the lowest 5-year CD rate you’re willing to accept?