In 2007, the Federal Open Market Committee (FOMC) began lowering Fed funds with the last drop on 12/16/2008 when they went to the range of 0.00% to 0.25%. Certificate of Deposit rates have been marching down ever since. 1-year CD Rates are hovering around 1.00% and 5-year CDs around 2.00 to 2.25%. The FOMC doesn't appear to have any plans to raise short-term rates anytime soon, but the markets have been pushing longer-term rates higher since December. So with rates so low, why would you still want to invest in CDs?
First, if you pick an FDIC insured bank or NCUA insured credit union, the funds deposited into the CD are insured up to $250,000. So unlike with the funds you put into the stock market, you can't lose principal. While it has been true that with longer investment horizons, the stock market has outperformed CDs, you may not have the time any more to make up for losses. In addition, you may not have the stomach for it. I'm still relatively young, but even I find it hard to not worry about the ups and downs of my portfolio. Certificates of Deposit gives you a peace of mind with a known rate for a known period of time.
Second, depending on the type of CD, it may have features that stocks and other investments don't. If you have a traditional, fixed term CD, it usually has a penalty for early closure. Penalties can be quite high, but they can also be rather attractive such as 90-Days or 180-Days. If your stock portfolio takes a dive who knows what percentage of loss you could be selling for. If you had purchased a stock for $18/share and now it is $9/share, and if you must have the money, that is a 50% decline. If you have a CD and it was at 2.00% with a 6-month penalty, you are only losing 1%. Although closing CDs can be expensive, they can be much less expensive than liquidating stocks.
In addition, you can actually purposely purchase long-term (better yielding) CDs with early closures in mind. The fact is CD rates go up and down. That will always be the case. But with short-term rates being offered at about 50% of the yield of a longer-term CDs, you can purchase the longer-term and pickup the difference in yield. As rates rise, you can then close the CD, take the penalty and take advantage of the higher rates.
Here are a couple of examples. Let's say today, you are offered 1.00% for 1-year and a 2.00% for 5-years. If you take the 1.00% and invest $100,000, you will earn $1000. If you took the 5-year you would have earned $2000. Going the 1-year route, CDs would need to be at 3.00% next year just to break even with the 5-year CD. Will 1-year CDs be at 3.00% next year at this time? Of course, in the next two years, they could be. Matter of fact, they could be even higher. But timing the CD market is not possible.
If you take the 5-year and it has a 6-month early withdrawal penalty, it allows you to semi-time the CD market. You will earn 2.00% until you decide it is time to close that CD. If in two to three years, CD rates have moved to 3.50% or above it could be time to close the CD and move it to a higher yielding one. Let's use our favorite $100,000 investment amount to plug in some numbers. (Note: I purposely used future dates to mimic a potential real scenario)
Current CD:
Principal: $100000
Rate: 2.00%
Maturity: 1/1/2016
Analysis: 1/1/2013
Penalty: 180-Days
Earnings: $6,000
New CD:
Principal: $100000
Rate: 3.50%
Maturity: 1/1/2018
Analysis: 1/1/2013
Earnings: $10,500
If you close the current CD the penalty would be $997.26. The net earnings after the 3-years is $3,502.74, almost $1200/year. Your net effective rate over the 3-years would be 3.17%. That is certainly a very decent increase in earnings and yield. Certainly a good reason to purchase some longer-term CDs. I will make one caveat. Most banks disclosures read to the effect that the penalty will be charged if they consent to the request to close. This means it is possible for a bank to deny the closure request. However, in our twenty years of business, this has only happened twice.
Other features that a CD can have our step-ups or bump-ups. A step-up CD has predetermined time frames when the rate increases. For example you may find a 2-year step-up CD that starts at 1.20% and then every six-months the rate increases a predetermined amount. Usually, a step-up CD will have a start rate that is below current rates for that term, but the average rates work out to where it is a little better.
Bump-up CDs give you the option of moving the rate up, if the rates increase on that term at a later point. For example, you may find a 3-year CD at 1.50% with a one-time bump feature. This means that if rates rise on the 3-year term to say, 2.50% after 2-years, you can call the bank and have them move your rate up. An unfortunate trick I have seen is banks will offer bump-ups on an odd-term Certificate of Deposit like 37-months. During that 37-months, they purposely don't increase the rate even though rates on other terms did increase. Thus you never have the ability to increase your rate.
To sum it up, the stock market can give some great returns. But you have to be able to take the ups and downs. CDs offer protection of your principal and provide you a stable rate of return. Using some of the features as noted above can help you increase your CD returns. Please visit us for more info on current rates or answers to other questions that you may have.
Chris Duncan is a FINRA Registered Representative. He works for Jumbo CD Investments, Inc., a leading CD research and placement firm. He specializes in helping clients find the highest CD rates nationwide. His clients include individuals, financial institutions, corporations, and public agencies. Visit us for the Best CD Rates
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