Tuesday, July 6, 2010

The Right Way to Own a Certificate of Deposit

I have noticed a form of capitulation in my office over the last few years. Due to low interest rates on savings, businesses and individuals have frequently decided to accept the lowest return possible and in many cases, zero.

Savers should not accept the short-term rates in today’s market. It is possible to double your rate of return without any additional risk.

Individuals and business frequently allow funds to languish in checking, savings, or money markets accounts earning under ½%. Short-term money has a habit of lasting longer than expected. Businesses that keep a cushion of funds available almost always have this cushion in place. Individuals keep an emergency fund at a steady level most of the time.

Other investments offer higher returns with additional risk. Even if you have funds in the stock market, you also have money in the bank or credit union. You can settle for ½% or less on this money or earn up to 3% if managed correctly.

As I write, one-year CDs are paying 1.2% at local credit unions; four-year rates yield 2.6%. Four-year CDs are down from over 3% only a few short weeks ago. Still, 1.2% is better than ½% or nothing and 2.6%, while still a meager return, is better than 1.2%.

Using the above information, money that is saved for 1-year or more should be invested in the highest rate CD possible, regardless of the term. Here is why: If you buy a 4-year CD with a 2.6% yield and decide to cash it in prior to maturity, you will pay a six month interest penalty. Running the math illustrates this principle better:

Example 1. You buy a 4-year CD at 2.6%. One year from now you either need the money or have the opportunity to invest it at a higher rate of return. You cash in the CD and pay a six month penalty. For 1 year you earned 2.6% minus the penalty of 1.3%, leaving you with 1.3%. This beats all one-year CDs; most 2-year CDs, too. If you keep the money in the CD longer due to continued low interest rates you still earn at 2.6% while you wait for higher return opportunities.

Example 2. You buy a 4-year CD at 2.6%. A year from now interest rates climb. The math is the same as the above example. You will earn 1.3% after penalty if you cash in the 4-year CD. You can now invest in the new, higher rate CDs. If interest rates stay low longer, you get the best yield while you wait.

The lesson learned: Do not fear early withdrawal penalties on CDs in low interest rate environments. The lower interest rates are, the cheaper it is to cash in a CD early and reinvest in the higher yielding CDs of the future.

Short-term money you must use in less than a year can still make a little return in a money market or CD. Rates are under ½%, but this is better than nothing. Take the ½ %.

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