Most savers and investors understand that the value of
bonds and bond mutual funds will decline when interest rates rise in the
future. Therefore, in an attempt to
avoid such losses, many people are keeping their cash in money market funds,
short-term bonds and bond mutual funds, and in short-term certificates of
deposit (CDs). However, interest paid at
the short-end of the yield curve is miniscule.
By saving and investing at the short-end, savers and investors may be
able to avoid a loss in value on their savings when interest rates rise, but
this strategy comes at a cost of receiving less interest while waiting for
rates to rise.
Money Magazine recently suggested a strategy using bank CDs
to earn extra income during the wait for interest rates to rise. Look for a bank that charges low early
withdrawal penalties, and then purchase a long-term CD instead of a short-term
CD. If interest rates remain low for an
extended period, the long-term CD will yield more income than using short-term
CDs. When interest rates rise, cash in
the long-term CD early in order to reinvest in new, higher rate CDs. By cashing in the CD early with the issuing
bank you will only lose a portion of the accrued interest and not principal. This CD strategy enables you to earn extra
interest while waiting for interest rates to rise. The strategy won’t make sense if you have to
sell a long-term CD in the marketplace because the rise in interest rates will
reduce the sales price. So purchase
long-term CDs directly from the issuing bank.
For example, as of February 1, 2013, Ally Bank paid 0.99% on a one-year CD and 1.59% on a five-year CD. Ally charges an early withdrawal penalty of 60 days’ interest if the CD is cashed in before maturity. Assume that short-term interest rates rise to 2.00% two years after purchasing the CD. An investment of $100,000 into a one-year CD that is rolled over for the second year at the same rate would earn $1,989.80 of interest over two years. On the other hand, if a five-year CD were purchased, it would earn $3,205.28 over two years but suffer a 60-day early withdrawal penalty of about $265.53, netting $2,939.75. This is $949.95 more than using one-year CDs, or about 48% more income!
UPDATE
Ally Bank has caught wind of this strategy and effective December 7, 2013, their early withdrawal penalty policy changes as described below. The change doesn't render this strategy ineffective, but it does cut back some of the benefits. In the example above, the new 150-day early withdrawal penalty would be $663.81, reducing the benefit to $551.67.
"Early Withdrawal Penalty for CDs
We will be changing our early withdrawal penalty for longer term Ally Certificates of Deposit (CDs) and Individual Retirement Account (IRA) CDs. Any CD or IRA CD with a term of three (3) years or longer that is opened or renewed on or after 12/07/2013 will have the following early withdrawal penalty structure:
- 3-Year CD – loss of 90 days interest
- 4-Year CD – loss of 120 days interest
- 5-Year CD – loss of 150 days interest
Many of our CD's are unaffected by this change:
- Any CD or IRA CD with a term of three (3) years or longer that was opened before 12/07/2013 will continue to have an early withdrawal penalty of 60 days' loss of interest until it matures. The withdrawal penalties shown above will apply if the CD is renewed for another term.
- No Penalty CDs will continue to have no early withdrawal penalty after the first six (6) days after funding.
- There is no change to CDs or IRA CDs with terms of less than three (3) years. They will continue to have an early withdrawal penalty of 60 days' loss of interest."
