CD Ladders--why not go long and maybe pay a withdrawal penalty

[samclem]

More info: A local credit union (Wright Patt FCU):
5 yr CD: 3.78% interest
2 yr CD: 1.98% interest

Early withdrawal penalty on 48-72 month CDs: 12 months of interest.

That's a pretty big rate differential. Even with the hefty early withdrawal penalty, I think many folks would be ahead of the game at the end of two years if the tax deductability of the penalty is factored in.
(subsequent edit: See latest posts from kaneohe and FIREdreamer regarding tax deductabilty. The break-even point for the calc above will be slightly more than 2 years).

 

[samclem]

I suspect the latter statement is not true and that the simple-minded calculation gives the true and correct answer. I think the way it works is that the bank credits you for the full interest on your 1099 (e.g. if you break the CD at 1 yr, 1 yr of interest is attributed to you....which you report as interest.
You then report the 6mos. of penalty as a deduction. The net result is that you have reported 6 mos. of interest. You get no additional reward.

So the bank over-reports to the IRS what they paid me in net interest?
Anyway, the bottom line by your method does make sense--I pay no tax on the interest I didn't earn.

 

[FIREd]

Using USAA's CD rates:

https://www.usaa.com/inet/ent_utils/McStaticPages?key=bank_cd_rates

I calculated that the break even point is 2 years for the 5-year CD and 3 years for the 7-year CD (the 5 year CD has a 180 day interest penalty and the 7 year CD has a 365 day interest penalty).

 

[kaneohe]

A local credit union
5 yr CD: 3.78% interest
2 yr CD: 1.98% interest

Early withdrawal penalty : 12 months of interest.

. Even with the hefty early withdrawal penalty, I think many folks would be ahead of the game at the end of two years if the tax deductability of the penalty is factored in.

close but not quite: 3.78% (5yr) vs 3.96%(2yr) IF FIREdreamer and I understand correctly....might be affected slightly by compounding and make the differential a bit smaller. Still, might be worth the gamble rather than waiting for rates to rise.

 

[kaneohe]

So the bank over-reports to the IRS what they paid me in net interest?
Anyway, the bottom line by your method does make sense--I pay no tax on the interest I didn't earn.

I think they are reporting the gross interest. The penalty is reported separately which is what you get to deduct.

 

[smjsl]

I think they are reporting the gross interest. The penalty is reported separately which is what you get to deduct.

That is correct. You get full interest you earned on 1099-INT in box 1 and interest penalty of N months is then reported separately in box 2 of the same form.

 

[kaneohe]

One nice thing about this technique is that it takes the emotion out of the decision. I know even people w/ ladders (including myself) faced w/ an environment like today have the temptation to "meddle" w/ their ladders.........last time this happened after the 2000 bubble, I stayed liquid after some CDs matured because rates were so low. Eventually I lost patience....don't remember how long but it seemed like a few yrs......and went long. Of course, rates took off soon after. If I had just reinvested in the 5 yr CD when the original matured, the rate wouldn't have been great but I would have had a 2 yr head start over the much lower money market.

 

[free4now]

I'm a bit more short time horizon since I'm new to CD investing, just looking at CDs as an temporary alternative to bond funds due to the strange interest rate environment we are in now.

I'm thinking about putting a portion into 12 month CDs which pay 2% (as a buffer against the need to make early withdrawals if I need the cash for some reason), and then instead of putting the rest into 3 year CDs paying 2.5% as I would have before this thread, getting 5 year CDs at 3% (or even 7 year at 4%) and getting ready to pay the early wd penalty.

But what sounds best of all is the ability to lock in a particular CD rate with a minimum (e.g. $500) contribution and being able to add more later... seems like there would be people arbitraging that away since it's basically free money if interest rates fall. Anyone found lists or pointers to banks that allow locking in rates like that?

 

[free4now]

Darby Direct is offering another good online CD deal. It's a 2.50% APY 18-month CD. It's called a breakable CD since it has an option to withdraw any amount without a penalty once during the term (after 90 days from the issue date). Minimum deposit is $500, and it has no maximum deposit. This special is listed at this Darby Direct webpage as of 11/15/2009.

May not be available to all, and Danby isn't in real good shape....

FYI, I just clicked on the apply page for Darby and they said at this time they are only taking applications for Georgia residents, so at least that's one less thing to consider.

 

[deepc]

The only thing to ponder beyond the pure mathematics of it is the possibility that the bank won't let you take a penalty and withdraw. I like USAA as much as the next guy, but this line on p. 11 of the Depositary Agreement concerns me:


"If Bank consents to an early withdrawal, Bank will withdraw interest before
principal. If your account has not earned enough interest to cover the early
withdrawal penalty, ..."

IF Bank consents. Hmm.

 

[wolf]

FyI...Free4now....Alliant credit union, pays 2% on savings account. No need to lock in a 2% 1 yr. CD.

However, no guarantee, the 2% savings rate will endure. Check out Alliant. Has a pretty good reputation.

 

[free4now]

FyI...Free4now....Alliant credit union, pays 2% on savings account. No need to lock in a 2% 1 yr. CD.

However, no guarantee, the 2% savings rate will endure. Check out Alliant. Has a pretty good reputation.

Thanks for the tip; Alliant does seem to have better CD rates as well; in many cases investing $25k (jumbo in their world) with them will give you the same rates as PenFed for a year less duration:

1 year jumbo 2.27%
18 month jumbo 2.37%
2 year jumbo 2.5%
3 year jumbo 2.96%
4 year jumbo 3.2%

I'd rather lock in 2.27% for a year than put it into a savings account paying 2% that can fall at any time, because this is money that would otherwise be in bonds for me.

 

[smjsl]

The only thing to ponder beyond the pure mathematics of it is the possibility that the bank won't let you take a penalty and withdraw. I like USAA as much as the next guy, but this line on p. 11 of the Depositary Agreement concerns me:


"If Bank consents to an early withdrawal, Bank will withdraw interest before
principal. If your account has not earned enough interest to cover the early
withdrawal penalty, ..."

IF Bank consents. Hmm.

Yes, I had passed on a similar plan in one of the banks (or was it credit union? don't recall) in the past because of this reason exactly. Even though when I called, the CSR did not know why they would not consent and tried to convince me to ignore this rule, I figure if it's part of rules, I can't rely on them to consent. Of course, when I asked for any kind of assurances (in writing) that they would allow me to withdraw early with applicable penalties but without their approval, I did not get very far...

 

[Texas Proud]

Yes, I had passed on a similar plan in one of the banks (or was it credit union? don't recall) in the past because of this reason exactly. Even though when I called, the CSR did not know why they would not consent and tried to convince me to ignore this rule, I figure if it's part of rules, I can't rely on them to consent. Of course, when I asked for any kind of assurances (in writing) that they would allow me to withdraw early with applicable penalties but without their approval, I did not get very far...

The only time they would not consent is if you had a lot of money with them.... or possibly there was a run on the bank...

 

[ziggy29]

I suspect that if the yield curve continues to be fairly steep and short-term yields stay close to zero, we'll see steeper penalties or restrictions on early withdrawals.