I know many people are wary of CDs because they don’t want to tie up their money for long periods of time. It’s hard to want to commit to a long term CD especially when rates are so low. The general feeling is “rates have to go up eventually and then I’ll be stuck with a low rate!â€
While not all CD rates [1] are currently worth it (for instance I’m not advocating using a CD when you’re getting a better rate on your on-line saving account) some are and it helps to do the math. For an example I’ll use actual rates and penalties that I chose when moving some money to a 5 year CD last year. (rates and penalties are real – dollar amounts fictional for nice roundness) I’m also using straight interest rather than compound for simplicity.
source:kjgarbutt [2]
My CD Story
Last year I had $10,000 in a savings account earning 1%. This is $100 / year. My local credit union was offering a 5 year CD at 2.5%. This is $250 / year. The penalties for this CD are 3 months of interest if you’ve held it for a year or less and 6 months of interest if you’ve held it for more than a year. For current rates, you can check out the CIT Bank CD Rates to achieve your goal [3].
The Breakeven Point
What I look for in CDs is my breakeven point. This is the point at which if I hold on to the CD long enough it will have been worth taking out because it would equal what I was making in the savings account. Anything beyond the breakeven point is extra $.
How It Works
For example if I held onto it for 3 months I would have $0 in interest (3 months interest – 3 months interest penalty). This obviously would not have been worth it because I’d have been making money if I left it in savings. If I held onto it for 5 months I would get 2 months worth of interest (5 months interest – 3 months penalty). 2 months interest = $10,000 * .025 * 2/12 = $41.67
What would I get if I’d kept the money in my savings account for 5 months? $10,000 * .01 * 5/12 = $41.67. This is the same as the CD. So as long as I kept the CD for 5 months I would breakeven. If I kept it for longer I would come out ahead.
But wait – what about the increased penalties after 1 year? We need to check this out as well so we’ll look at the worst case – 13 months. If I cashed out the CD after 13 months I would get 7 months of interest (13 months interest – 6 months penalty). 7 months interest = $10,000 * .025 * 7/12 = $ 145.83.
What would I get if I’d kept the money in my savings account for 13 months? $10,000 * .01 * 13/12 = $108.33. So I’d still come out ahead with the CD even when the penalty increased.
I knew I could hold the money in the CD for at least 5 months (though probably not 5 years) so I made the move. But you might be thinking to yourself “Why bother? It’s only a point and a half difference. 2.5% is still low.†If you keep $10,000 at 2.5% for 5 years you’ll have $1,250 vs. $500 at 1% savings ($750 more). I know that I can move out of the CD anytime if interest rates move up because I’ve already crossed the breakeven point. So don’t be scared about the long term commitment of CDs. Your only real commitment is the breakeven point. Everything after that is just extra money.
Epilogue
What has happened in the 8 months since I’ve moved my money? My savings account interest has moved down 2 times. It’s now at 0.8%.