Saturday, December 4, 2010

CD Update

Certificate of Deposit (CD) rates have decreased a bit since I first wrote about the Ally Bank 5-year CD and the PenFed 7-year CD. As of today, the Ally Bank 5-year CD APY is 2.40%, and the PenFed 7-year CD APY is 3.25%. The Ally 5-year CD still works well for taxable accounts, but I now prefer the PenFed 5-year CD at 2.75% APY for IRA accounts because of the smaller early withdrawal penalty (explained in more detail later).

Ally Bank 5-year CD

The APY on the Ally Bank 5-year CD has declined from 2.74% in mid-September to the current rate of 2.40%. I’ve been waiting for rates to turn around and start heading higher, but instead they’ve just kept dropping.

Remember that you cannot do partial withdrawals from Ally CDs, so if you think you may need the money in less than 5 years, you should buy several smaller CDs. For example, you may want to buy a couple of $5,000 CDs instead of one $10,000 CD.

Also remember that the Ally Bank CD early withdrawal penalty is only 2 months of interest, so if you break a 2.4% CD at 4 months, you still will earn about 1.2% APY, which is better than most savings or money market accounts. This is why the Ally 5-year CD makes sense for money you are unlikely to need in less than 4 months. With multiple CDs, you can do an early withdrawal from one of the CDs to get some cash, pay a small penalty, and still end up having made more interest than if you had left it in a savings account.

One other note on the Ally CDs: I set them up as Payable on Death (POD) accounts, and designate beneficiaries for each CD. I started with Ally using a living trust, but have found that it’s much easier to open POD CDs; you can do it online and fund them immediately from an Ally savings or checking account, whereas with a trust you must do it by phone, and it takes a few days. Upon death, POD account assets are distributed outside of probate, as are living trust assets. Also note that with a trust or POD account, the base FDIC insurance limit of $250,000 is multiplied by the number of beneficiaries; e.g., if you have 2 beneficiaries named on a POD account (CD, savings, checking, etc.), your account is insured up to $500,000.

PenFed IRA CDs

The transfer from my Fidelity IRA to the PenFed IRA CD in November went smoothly. Being satisfied with the experience, and not being able to think of any reason not to do so, I decided to transfer more from my Fidelity IRA into another PenFed IRA CD. So, I recently mailed the short form to initiate another transfer.

This time I chose the PenFed 5-year CD paying 2.75% with a maximum early withdrawal penalty of 6 months of interest (if you break the CD in less than 6 months, you only lose whatever interest you would have received to that date). The rate on the 7-year CD recently dropped to 3.25%, and with a maximum early withdrawal penalty of one year of interest, it will yield less than the 5-year CD if you do an early withdrawal up until about 4 years, or if you hold the 5-year CD to term.

For example, if rates rose significantly over the next year, you could break the 5-year CD, receive about 1.38% interest, and reinvest in a new higher-rate CD. With the 7-year CD you would receive 0% interest if you broke it after 1 year.

The 7-year 3.25% CD would end up better if rates didn’t increase much in the next 7 years, but I prefer sacrificing a little potential interest in exchange for the smaller penalty to break the 5-year CD and reinvest if rates rise significantly.

A formula for approximate effective APY upon early withdrawal is:

Stated APY x (1 – penalty period / holding period)

For example, if you broke the 5-year PenFed CD (penalty period = 6 months) after 3 years (holding period = 36 months), the effective APY would be about:

2.75% x (1 – 6/36) = 2.29%

And for the PenFed 7-year CD (penalty period = 12 months):

3.25% x (1 – 12/36) = 2.17%

So, we see that the 5-year CD works out slightly better than the 7-year CD if you do an early withdrawal after 3 years.

You might want to do an early withdrawal if rates were to increase significantly. You would pull the money out of the lower yielding CD, pay the relatively small early-withdrawal penalty, and put the proceeds into a new higher yielding CD (in the case of an IRA, you could keep the money within the IRA, but just move it from one CD to another). For example, if 5-year CD rates were to double and you had more than 6 months left to maturity, you would come out ahead breaking the lower-yielding CD and investing in the higher-yielding CD, since you would recoup your lost interest in about 6 months, and then start pulling ahead.

Your Money is Safe

Remember that Ally Bank CDs are FDIC insured and PenFed CDs are NCUA insured, so as long as you stay within the insurance limits (basically $250,000 per bank or credit union), your money is safe.

If a bank fails, the acquiring bank either honors the terms of the CD, or the CD is liquidated and you receive your principal and interest (interest is paid to the day of failure), usually very quickly. Over the years I’ve had CDs with several banks that have failed, and I’ve received the money for liquidated CDs within less than a week. So worst case, you lose a few days of interest.

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