By Garrett Fisher
March 1, 2011
We have all heard the same phone call on the investment radio or TV shows. “I have a significant sum of cash and would like to invest it for a year or two before I need it. What is the best place to invest?” The answer? Always “Certificates of Deposit.” The shock and dismay of the caller is generally amusing as a listener and yet representative of the same frustration just about every holder of cash faces: the quest for high, secure, federally-insured returns in relatively liquid instruments.
Of course, the first pass is always the local bank. Savings accounts interest rates are usuallly not worth even bothering – especially if there are any fees or restrictions whatsoever. Leaving it in a checking account is usually more compelling. CD rates at retail banking institutions are generally laughable given the time commitment and liquidity constraint. For those comfortable with dispensing of the local brach presence and transacting business on the internet, high-yield savings accounts have typically been the best option for savings. At present, the highest liquid FDIC insured savings account availaable is 1.4% APR.
The next logical step to increase yields higher than 1.4% would be to entertain CD rates from high-yield direct banks. In this case, the top tier is roughly 2.4% to 2.6% for 5 year CDs. Really, though – is a 5 year commitment worth 0.9% to 1.1% aditional APR? Highly unlikely – especially when considering talk of the Federal Reserve’s voluminous money printing and anticipation of high inflation rates sometime in the future. Middle-tier CD rates are usually no better – in fact, even worse when compared to the 1.4% floor of the savings account.
So, what options are there?
Typical investors will then start looking at treasuries, municipal bond funds and other bond options. Inflation-linked bonds are a popular choice. Caution is advised as the desire for higher yield may cause lapses in judgment and acquisition of comparatively high risk amounts for minimal additional returns.
Let’s go back to the caller in to the radio show. He is looking for safe, secure, high yield investment earnings over the next year or two as he will need to money at that point. Under the assumption that capital can be restricted, optionally, for a short period of time then lends itself to an unconventional option for interest earnings.
Let’s step back to the 5 year CD concept. Maximum cash returns with, of course, maximum restriction. The loophole is that many of the high-yield options include an early withdrawal penalty that is relatively modest given the nearly doubled interest rates compared to the savings account option. So what are we getting at here? Simply put, put capital into a 5 year high-yield CD with the presumption and anticipation of breaking the CD when interest rates rise or when capital is needed. Here are some scenarios.
In any strategy, we don’t want to reduce earnings by an errant set of circumstances. So, let’s say that we are currently the high-yield saver at an internet bank. At what point could we put my money into this CD, withdraw it for some unpredictable need, and still maintain effective interest earnings of at least 1.4% (the highest savings account available in the US)? 5 months. Effective APR (when factoring the time of the investment, higher 2.5% earnings less 2 months penalty). Essentially, the 3 months of interest that you are allowed to keep is enough to cover 5 months of high-yield savings account interest rates. We are basing our assumptions on Ally Bank’s 5 year CD terms.
At the one year point, if capital is withdrawn, the effective earnings translate into 1.99%. Certainly beating the 1.4% rate and also beating 12 month CD rates. Again, the basis is that 10 months of interest at 2.5% is enough to equal 1.99% over 12 months.
From there, the rate rises in year 2 to 2.28% (by month 24) and slowly climbs up to the 5 year CD rate. So, in short, the 1-2 year timeframe we are speaking of returns almost a full 1% higher than the savings option.
The Interest Rate Step Up
Part of the whole strategy (aside from capital access) is the ability to step up interest rates as rates rise. Nobody wants to be stuck with a lower than market rate in the future just to get better rates now.
Factoring a 2 month early withdrawal penalty, it is necessary for rates to rise 0.5% for the increased earnings to pay for the penalty in one year. Logically, then, it makes little sense to keep doing this frequently – especially if the Federal Reserve starts stepping rates up pretty quickly. Much like refinancing a mortgage, it is not smart to do it 3 times in a row and push out the ROI date 3 years due to repeated costs. Though there is no concrete requirement, it makes sense that if CD rates rise a full point, “refinancing” the CD (i.e. breaking it and re-entering into another 5 year CD) would make sense as it would take 6 months to earn back the withdrawal penalty with the higher earnings. Be careful. Make sure that the new CD still has a 2 month provision. If the banks do away with the 2 month provision at that time, wait until high yield savings rates increase enough to equal the present CD and consider getting out.
Additionally, be cautioned that, after the first “refinancing”, it is necessary to recalculate the necessary APR increase as it increases proportionally to the base CD rate. At 2.49% CD rates, it takes 0.5% APR increase for a one year return. If you refinance to 3.5%, it would take 0.54% to achieve a one year return on refinancing the CD for a second time.
Caution is in order based on the bank chosen. For example, Stonebridge Bank in Pennsylvania has the best 5 year rate hands down (2.65%). However, they have a staggered early withdrawal penalty – from 3 months increasing to one year. Obviously, meant to prevent this sort of strategy. Avoid it.
An additional concern is regarding partial withdrawals. Can you take part of the CD to cover an unanticipated need and then leave the rest in there without paying a full penalty on the entire balance?
Lastly, always maintain full sets of paperwork and documentation all CDs. I have experienced banks making errors on 2 year fee waivers and have had to show them copies of their website (glad that I printed it) when I signed up for various accounts to get the fee waived properly.