Invest in Long-Term CDs Without Fear of Commitment

August 20, 2014

Since the Federal Reserve Bank effectively lowered short term interest rates to near zero in the wake of the Great Financial Crisis, savers have been feeling the pain. The yield on risk-free investments in treasury securities and federally insured deposits has fallen below the rate of inflation, and many savers have given up and parked their money in money market and savings accounts where the annual earnings may not cover the price of a good lunch. 

Money deposited in certificates of deposit has declined as savers have been reluctant to lock in a low rate, afraid of being caught out when rates eventually rise.

Current CD rates are not very impressive when compared to the past, but CDs over one year can yield several times more than savings and money market accounts. Even better, current low rates can actually make it less risky to invest in a longer deposit term. Stay with me and I will explain.piggy bank

The Federal Deposit Insurance Corporation publishes average deposit rates on their website every week. If you want to feel depressed as a saver, you should check them out at the link below. The way the FDIC figures them, the rates being offered are divided by the number of branch locations where they are available. This biases the average downward, since the megabanks with their huge branch networks offer the lowest rates in the market. Fortunately, the big banks still have competition for deposits from many smaller financial institutions. With a little shopping, an astute saver can find rates much better than the FDIC averages and a lot higher than those offered by the big chain banks.

So why is locking in a longer-term CD less risky now? It’s because with rates so low, early withdrawal penalties are no longer much of a deterrent to reinvesting when rates go up, or pulling out the money when it’s needed for an emergency. The early withdrawal penalty on a CD can be thought of as the cost to exercise an option, but banks have historically not priced these “options” efficiently. Penalties are expressed as number of days of interest to be forfeited, and many banks still charge only 90 or 180 days of interest for their early withdrawal “option.”

This varies, of course, and you need to find out what a particular financial institution charges for a given term. Banks are required by law to provide full disclosures of rates, yields, fees, and penalties to consumers upon request and prior to opening a new CD account. You should also be aware that invasion of the principal amount is possible if there is not enough accrued and unpaid interest in the account to cover the penalty. This would happen if a withdrawal happened soon after the account was opened, or if interest were to be paid out frequently.

So let’s do the numbers. You have shopped around and found a 24 month CD yielding a whopping 1.00% that has an early withdrawal penalty equal to 90 days of interest. So your cost for exercising the early withdrawal option for a $100,000 CD would be about $247. An alternative would be to leave the money on deposit in a money market account yielding perhaps 0.20%. Figuring out the break-even term requires algebra, and I will spare you the calculation. But if you left your money in the CD for at least 128 days, you would be better off than if you had it in the low-yield money market account. At this point the higher yield on the CD would have more than made up the cost of the penalty, and you would be dollars ahead compared to the alternative.

By committing to the 24 month CD with a small early withdrawal penalty you will have put yourself in a position to make $1,000 per year from your $100,000 versus the $200 you might have realized from the money market account, and without assuming much additional risk. By shopping for rates and terms, you can take advantage of the inefficient early withdrawal “option” pricing and beat us bankers at our own game!

Because of our low cost operating model, Business Bank of Texas can offer its customers above average yields on our deposit products, both CDs and money market accounts. Check out our rates and watch for deposit product promotions that we will offer from time to time. Business Bank of Texas is a member of the FDIC.

FDIC Weekly Average Rates:

Topics: Featured, Accounting & Finance

Dwayne Kolly

Business Bank of Texas

Dwayne Kolly brings a wealth of financial management and operations experience to Business Bank of Texas. Kolly has served community banks in south and central Texas for nearly 30 years, and is the bank’s CEO and Chief Financial Officer. He is a graduate of the Southwestern Graduate School of Banking at SMU (1993).
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