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

[samclem]

Regarding CDs and CD ladders: Most folks buy CDs that mature at the time the money will be needed. Instead, what's the downside of buying them with a much longer maturity and just pay the withdrawal penalty if you need the $$ earlier? The withdrawal penaties are typically 90 days of interest, which isn't a lot.

Example: I want approx $20K available in my "cash bucket" in 2012. I'll use this money for may annual spending if my equities are in the hole.

Normal approach: Buy a 24 month CD. The best avalable rate is about 2.25% today. If I don't need the money in 2012, buy a new CD at the prevailing rate.

Alternate approach: Buy a 5 yr CD. Best available rate is about 3.25%.

Observations:
- If I need to withdraw the money in 2012, I'm better off with the 5yr CD even after paying the early withdrawal penalty.
- If I don't need the money in 2012 and CD rates have gone down, I'll be happy that I locked them in with the 5 yr CD
- If I don't need the money and rates have gone up, I'll still be better off with the 5 yr CD: pay the fee and buy a new CD at the higher rate.

I'm sure this is not a new revelation, but I haven't seen it talked about here.

In fact, why build a CD ladder at all? Take the whole "cash pot" and buy longer-term CDs. The same logic applies--but BIGGER!

 

[Texas Proud]

It is not a bad idea.... my father did this back in the 70s...



The big problem is that most people just do not want to break their CD... as an example... one of my sister's friends had two CDs in a bank... one was $250,000 and the other $200,000. The first was in her name, the second in her and her sister's name... I talked to her and suggested that she take out the second CD unless she absolutely knew that both were covered by FDIC insurance.... the bank she had them in was not in good shape and expected to be closed down...

Well, it was closed... the lady never did take the money out... she did not want to take the interest hit... I am not sure if all her money was insured, but the bank who bought the failed bank agreed to honor ALL deposits... so she might have been lucky...

So, even though it sounds good, most people would keep the low interest in 2 years..

 

[Alan]

Sounds like a solid approach to me but doesn't sound like "laddering".

I have always considered a CD ladder as never touching the principal and spreading the interest rate risk over 5 years. Buy a $100K 5 year cd, each year for 5 years. All with dividends re-invested.

In year 6 you take all the accumulated dividends of the 1st CD to mature and buy another 5 year CD, and so on...

Your example sounds like a "one-off" rather than a ladder.

 

[omni550]

Regarding CDs and CD ladders: Most folks buy CDs that mature at the time the money will be needed. Instead, what's the downside of buying them with a much longer maturity and just pay the withdrawal penalty if you need the $$ earlier? The withdrawal penaties are typically 90 days of interest, which isn't a lot.

Example: I want approx $20K available in my "cash bucket" in 2012. I'll use this money for may annual spending if my equities are in the hole.

Normal approach: Buy a 24 month CD. The best avalable rate is about 2.25% today. If I don't need the money in 2012, buy a new CD at the prevailing rate.

Alternate approach: Buy a 5 yr CD. Best available rate is about 3.25%.

Observations:
- If I need to withdraw the money in 2012, I'm better off with the 5yr CD even after paying the early withdrawal penalty.
- If I don't need the money in 2012 and CD rates have gone down, I'll be happy that I locked them in with the 5 yr CD
- If I don't need the money and rates have gone up, I'll still be better off with the 5 yr CD: pay the fee and buy a new CD at the higher rate.

I'm sure this is not a new revelation, but I haven't seen it talked about here.

In fact, why build a CD ladder at all? Take the whole "cash pot" and buy longer-term CDs. The same logic applies--but BIGGER!

I hadn't thought of this, but off the top of my head it sounds like a great idea.

One way to make it more palatable, would be to buy smaller individual CDs all for the same "maximum interest" term (say, 5 CDs for $20K each for 7 years, instead of one CD for the entire $100K for 7 years). That way, if you did have to make a withdrawal before maturity, hopefully, you'd only have to cash in one or two of the CDs early. Thereby, paying less of a interest penalty.

omni

 

[megacorp-firee]

I hadn't thought of this, but off the top of my head it sounds like a great idea.

One way to make it more palatable, would be to buy smaller individual CDs all for the same "maximum interest" term (say, 5 CDs for $20K each for 7 years, instead of one CD for the entire $100K for 7 years). That way, if you did have to make a withdrawal before maturity, hopefully, you'd only have to cash in one or two of the CDs early. Thereby, paying less of a interest penalty.

omni

That's what I did. Broke up into 8 cd's, 2 each maturing at the same time. If needed, I can cash one in and let the other run.

 

[kaneohe]

Be sure to doublecheck the penalty for breaking the CD. My experience is that for the longer CDs, it is more like 180 days of interest. For even longer maturity CDs, it might be a yr. Splitting them as suggested above is a good idea. Perhaps this strategy works or not depending on the steepness of the yield curve. If the yield curve were flatter, perhaps not so good. There was also some discussion that I read somewhere about whether you always had the right to withdraw early or whether that was at the discretion of the bank.......forget the conclusion of that but be good to doublecheck that also.

 

[brewer12345]

Read the fine print and break up the CD into smaller bits, but yes this is a perfectly reasonable strategy. I did it and will likely do the same when one of my Pen Fed CDs matures in January.

 

[FIREd]

There was also some discussion that I read somewhere about whether you always had the right to withdraw early or whether that was at the discretion of the bank.......forget the conclusion of that but be good to doublecheck that also.

With ING, redeeming a CD early has been always been straight forward in the past (all it took was one click). But now that I bank with USAA, I noticed that early redemption of a CD requires USAA's consent. I am not sure how often USAA denies a costumer's early withdrawal request, but it is something to keep in mind. Also, the penalty to redeem a 7-year CD early is 365 days interests.

 

[FurBall]

I've been playing with almost the opposite idea -- what I call CD Option Laddering.

All CDs at my credit union all CDs are add-on CDs; I can add money at any time and get the original rate until the date of maturity. It's a small credit union with limited field of membership and generally has outstanding CD rates.

Because I was concerned about potentially rising interest rates last year (was I ever wrong), I put a minimum $500 into a 2 yr CD at 3.75%. Recently I dumped more money into it resulting in what amounts to a 15 month CD at a great rate by today's standards.

I haven't modeled this in any detail, but it feels like it might be a good tactic in times of either interest rate uncertainty or decreasing interest rates.

Based on that I just got 2, 3, and 5 yr CDs putting in $500 for each.

I'd appreciate hearing opinions on this.

 

[LARS]

As already stated, anything over a year incurs a 6 month interest penalty.

 

[Goonie]

Be sure to doublecheck the penalty for breaking the CD. My experience is that for the longer CDs, it is more like 180 days of interest. For even longer maturity CDs, it might be a yr......

I have several CD's with ING, so I just popped over there to recheck the early withdrawal penalties, and they were as I'd remembered them.

From ING:

"For any Orange CD term that is 12 months or less, you'll forfeit 3 months of interest regardless of when, prior to maturity, you redeem. For any Orange CD term that's greater than 12 months, you'll forfeit 6 months of interest regardless of when, prior to maturity, you redeem."

I just cashed in one at out 'brick & mortar' bank Thursday, that was 4.78%. It's sitting in my bank account until they post the newest rates on Monday, to see if they toss a 'special' rate on the table.....which they do occasionally. The current rate there was only 1.33% on Thursday. The last time their 'special' was .01% less than the best rate I could find online, and they only offered it for 2 or 3 days, then the offered rates dropped back in the toilet.

So now samclem's and you others have given me some food for thought. Now I'm thinking about going for a longer term if I can grab a better rate, and then wait and see if something better comes along down the line, and if so, I can always draw the money out, pay the penalty, and go for the gusto....IF the newly found rate will make up the difference of what I lost in penalties, plus offer enough extra incentive to make it worth my while for the hassle involved.

 

[samclem]

Be sure to doublecheck the penalty for breaking the CD. My experience is that for the longer CDs, it is more like 180 days of interest. For even longer maturity CDs, it might be a yr.

As already stated, anything over a year incurs a 6 month interest penalty.

It looks like it definitely pays to shop around on this. Here's an older (2006) article about CD early withdrawal penalties. They did a big survey of over 100 banks in various metro areas and across various CD maturities. Examples for 5 yr CDs:
- In Houston, early withdrawal penalties varied from 90 days to 900 days.
- In New York, penalties ranged form 90 days to 360 days.


Now, a lot has changed in banking since 2006, but maybe there's still quite a difference between institutions in penalties. I couldn't find a more current list of early withdrawal penalties.

Here's another interesting quote from the article, referenceing waivers for early withdrawal fees:

There are some exceptions," says Theresa Brooks of Community Savings. " . . . Most institutions will also waive it on an IRA or 401(k) for anyone over 59."

Hmmmh. I could see where I might take them up on that offer.

- Yes, I can see that breaking things up into smaller CDs would help with the flexibility.

 

[Dawg52]

Read the fine print and break up the CD into smaller bits, but yes this is a perfectly reasonable strategy. I did it and will likely do the same when one of my Pen Fed CDs matures in January.

I can't believe I didn't go with 7 year maturities when I bought mine at 6+% a few years ago. Opted for 5 years and they mature 01/2012. Idiot.

 

[brewer12345]

I can't believe I didn't go with 7 year maturities when I bought mine at 6+% a few years ago. Opted for 5 years and they mature 01/2012. Idiot.

All about risk vs. reward. I made the same decision because I was unwilling to have a 1 year interest penalty in the case of needing to break the CD. You pays your money and you takes your chances. But this is small potatoes in the grand scheme of things.

 

[Trek]

I have a Citibank account in the U.S. Here's their current CD penalties:

The early withdrawal penalty based on the term of the CD will be assessed
as follows: 30 days simple interest for accounts 1 year or less; 90 days
simple interest for accounts greater than one (1) year up to and including
two (2) years; 180 days simple interest for accounts over two (2) years
but less than 5 years; and 270 days simple interest for 5 years or more.

Early withdrawal penalties are calculated on the amount of the principal
withdrawn.There is no early withdrawal penalty if the account holder dies
or is declared legally incompetent.

 

[Gone4Good]

Normal approach: Buy a 24 month CD. The best avalable rate is about 2.25% today. If I don't need the money in 2012, buy a new CD at the prevailing rate.

Alternate approach: Buy a 5 yr CD. Best available rate is about 3.25%.

It looks like a holding period of a little less than two years is break even between the two CDs using a 6 month break fee. So by going the 5-yr route, you're getting a slightly better 2-yr yield, with a free option to extend an additional 3 years at 3.25%. So yeah, the 5yr CD sounds like the better choice.

It wouldn't be too difficult to set up a spread sheet to calculate these break even holding periods assuming different rates and pre-payment penalties. My guess is that the economics change all the time based on the yield curve. But it looks like there are times when the pre-payment option isn't being accurately priced.

 

[Ed_The_Gypsy]

Trek,

You might be in a good position to use ING's CD's (if they still have their no-penalty cash-out feature). As I understand it, ING is all on-line banking.

Cheers,

Ed

 

[samclem]

It wouldn't be too difficult to set up a spread sheet to calculate these break even holding periods assuming different rates and pre-payment penalties. My guess is that the economics change all the time based on the yield curve. But it looks like there are times when the pre-payment option isn't being accurately priced.

Other tidbits:
- As mentioned previously, if the bank offers penalty-free withdrawals from IRAs after 59 1/2, that would be a game-changer. Just pick the highest rate.
- Early withdrawal penalties are tax deductible. That would make the break-even date for the "5 yr and take the penalty" option even earlier.
- I'm still searching for an online table listing CD rates and withdrawal penalties, I'm sure it's out there.

There are people who study the CD biz like hawks, they live on their CDs and know every angle. It's also likely there's an online calculator somewhere that incorporates CD rate info, penalty info, and customer tax rate to allow people to quickly find the best deal. But, I haven't found it.

 

[kaneohe]

- As mentioned previously, if the bank offers penalty-free withdrawals from IRAs after 59 1/2, that would be a game-changer. Just pick the highest rate.

- Early withdrawal penalties are tax deductible. That would make the break-even date for the "5 yr and take the penalty" option even earlier.

samclem........thanks for that tidbit on penalties being tax deductible. They are above-the-line deductions (like IRA contributions) so even if if you don't itemize, you can still deduct them.
http://www.irs.gov/pub/irs-pdf/f1040.pdf

It might be useful for folks to share what banks offer those penalty-free withdrawals for IRAs after age 59.5. The only one I know is PenFed CU.
I know you can't do that w/ Schwab (brokerage) CDs......you have to sell on secondary market tho w/o a specific penalty.

 

[harley]

I can't believe I didn't go with 7 year maturities when I bought mine at 6+% a few years ago. Opted for 5 years and they mature 01/2012. Idiot.

I think you've probably got a 50/50 chance that you can match or better that rate in 2 years. Just because interest rates are in the toilet now doesn't mean they'll always be. I personally wish I'd locked in those 14.5% cds I had back in the early 80s for 50 years. But I'm sure glad I'm not carrying my old 15.75% mortgage anymore. The only thing constant is change.

 

[smjsl]

Good topic.

Couple points
- If penalty is calculated based on early-withdrawn amount, I imagine breaking up a CD does not make sense.
- If you do break up a CD (presumably because the penalty would be on overall CD amount), break it up UNEVENLY. E.g. if you have 100k cd, if you don't know how much money you may need early, break it into 35 and 65k - it gives you more options than 50k/50k break. Of course you can also have more than 2 CDs.. so you could make it 5k,10k,25k,60k to cover almost any amount you may need to withdraw (unless there are jumbo-rate-minimums).

@kaneohe: 5/3 bank has those (used to have a good rate some time ago, don't know now).

 

[calmloki]

Went looking for PenFed's penalties - think these are current:

2) Certificates Having a Term Greater Than
Six Months and up to and including 5 years.
a) If redeemed within 180 days of the issue
date or any renewal date, all dividends will be
forfeited.
b) If redeemed thereafter, but prior to the
maturity date, dividends for the most recent 180
days will be forfeited.
3) Certificates with a term of 7 years.
a) If redeemed within 365 days of the issue date
or any renewal date, all dividends will be
forfeited;
b) If redeemed thereafter, but prior to the
maturity date, dividends for the most recent 365
days will be forfeited.

And here are the current rates:
MONEY MARKET CERTIFICATE RATES

Term APY

6-Month 1.00%**

1-Year 1.25%

2-Year 1.75%

3-Year 2.50%

4-Year 2.75%

5-Year 3.00%

7-Year 4.00% $1,000 minimum deposit
Rates are accurate as of 11/15/2009

Looks to me like if you wanted to rathole some money for 2 years you could buy 5 year certificates, earn $6/hundred, pay the tax deductible $1.50 penalty, and end up with 2.25%/year - better than the 1.75% 2-year rate they quote. Nice plan Samclem!

Another possibility as reported here http://bankdeals.blogspot.com/ is this:

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....

 

[samclem]

Here's what I found ot from Ally Bank (aka GMAC, they are advertising everywhere).
For CDs with a term over 13 months, the penalty for early withdrawal is 180 days of interest. Their 5 yr CD is paying 3.10% today. Their 2 year rate is 2.20%. By the same math Calmoki used, you'd still be ahead buying the 5 yr CD and paying the penalty.

They don't handle IRAs.

 

[kaneohe]

.
- Early withdrawal penalties are tax deductible. That would make the break-even date for the "5 yr and take the penalty" option even earlier.

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.

 

[FIREd]

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.

That was my understanding as well.