Monday, October 4, 2010

Ally Bank 5 Year CD

With interest rates so low, one of the best deals for fixed-income investing in a taxable account is a 5 year CD from Ally Bank. One advantage of Ally CDs is that the penalty for early withdrawal is only 60 days of interest, as compared to 6 months to 1 year of interest at other banks and credit unions. Currently Ally Bank doesn’t offer CDs for IRA accounts (although they plan to in the near future), so the 5 year CD I’m recommending only makes sense if you have quite a bit of money in a taxable account. Following are some more details about why this CD might make sense for some of you.

First some basics. CD stands for Certificate of Deposit. Most CDs are insured up to $250,000 per bank (either by the FDIC for banks or NCUA for credit unions), so they are a very safe investment; Ally CDs are FDIC insured. With a CD, you deposit money with a bank or credit union for a designated amount of time (the term), and you receive a specified interest rate. By locking up your money for a period of time, you usually get a higher interest rate than the bank or credit union would pay you for money in a savings account. Usually longer-term CDs pay higher interest rates than shorter-term CDs.

To illustrate, here are some rates (expressed as APY) offered by Ally Bank as of 10/3/2010:

  • Online Savings Account: 1.24%
  • 12 month CD: 1.37%
  • 3 year CD: 2.04%
  • 5 year CD: 2.64%

Note that the 5 year CD is paying more than twice as much as the savings account. The beauty of the Ally 5 year CD is that if you keep the CD for at least 4 months, you’ll end up making more than you would in the savings account at the current rate. If you “break” the CD (withdraw your money before the end of the term) after 4 months, you’ll lose about 2 months of interest and keep 2 months of interest; i.e., you’ll keep half of the interest. Since the 5 year CD rate is more than twice the current savings account rate, half of the CD interest for 4 months will be more than the full 4 months of interest on the savings account at the current rate. After 4 months, the longer you hold the CD, the more your rate will exceed the current savings account rate; e.g., if you break the CD after 1 year, you’ll lose about 2 months of interest and keep about 10 month’s interest, for a yield of roughly 2.2% (2.64% * 10/12 = 2.2%).

If rates hold steady or decline, you keep the CD and get the higher 5 year rate. If rates rise significantly, you can break the CD, sacrifice 2 months of interest, and reinvest at the higher future rate, either in another 5 year CD or whatever other investment is paying a higher rate at the time. With this flexibility, this CD makes sense for any cash you are likely to hold for more than 4 months.

In the current low-rate environment, an Ally 5 year CD has a much better risk/return profile than a high-quality bond mutual fund. With short-term bond fund rates between 0.5% and 2%, and intermediate-term bond fund rates between 1.5% and 3.3%, there is plenty of downside risk due to the potential for higher future interest rates (bond prices fall when interest rates rise), and not much upside potential due to the current low rates. The Ally 5 year CD gives you a guaranteed rate of return in the range of an intermediate-term bond fund, with much less risk than a short-term bond fund. For example, if short-term rates were to rise 1%, you would lose about 2% on a short-term bond fund (assuming a 2 year duration), and your total return over 1 year would be about 0% (2% interest minus 2% decrease in value). By contrast, we’ve already seen that you’ll make a minimum of 2.2% on the Ally 5 year CD in 1 year (assuming you break the CD in 1 year).

Note that you can still get higher rates (3%-4%) on some reward checking accounts on amounts up to $25,000; this is why I said the 5 year CD makes sense if you have quite a bit of money (i.e., more than $25,000) in a taxable account. It also makes sense if you don’t want to hassle with the requirements of a reward checking account; e.g., making 12 debit-card purchases per month. See my blog post Your Cash Stash for more details on reward checking accounts.

With Ally CDs, you might want to purchase several smaller CDs instead of one large one, since Ally does not allow partial early withdrawals from CDs. This gives you the flexibility to break one of the smaller CDs if you need the money, and only pay the penalty on the one smaller CD. For example, rather than opening one $50,000 CD, you might open five $10,000 CDs; then if you need some money, you can break one $10,000 CD, paying only the penalty for that CD, keeping $40,000 plus accrued interest in the other four CDs.

1 comment:

  1. Thanks for an idea, you sparked at thought from a angle I hadn’t given thoguht to yet. Now lets see if I can do something with it.