What is your highest current CD interest rate?
As bankers, we become used to hearing our customers ask this question. Recently, customers have been disappointed with the answer.
We are in a time of historically low interest rates. Regardless of what bench mark rate you examine…the Federal Funds Rate, Prime, or U.S. Government Securities… rates are low. While this is very good news for consumers that need or want to borrow money, it is bad news for investors and savers.
Rate, or APY, is an important component of making an investment decision. However, other factors are also important to insure the best decision is made for your unique situation.
Investors generally consider three factors when choosing where to invest.
1. Rate – Return on investment
2. Risk – Probability that you will lose money
3. Liquidity – Accessibility to your money
Each investment option fairs a little differently on each of these factors and no option gives you a “perfect” combination (high rate, low risk and easily accessible).
Consumers wanting to invest in a CD are typically risk adverse. This means they want to insure preservation of their principal. Banks are a relatively safe place for people to invest in CDs and as long as your bank helps you manage your money correctly, you will not risk losing principal.
Investing in CDs does not automatically mean you are avoiding all investment risk, there are other risks to consider. Anytime a CD investor places a majority of CD funds in one maturity term, the investor is exposed to interest rate risk.
Well…what does that mean?
Let’s suppose a CD investor has $50,000 to invest in a bank CD. The investor shops the competition and determines that bank “X” currently has the best deal. Let’s suppose that bank “X” is currently offering an 18 month CD “special” with an APY of 1.0%. Since this is the best “deal” in the market, the investor makes the decision to purchase that CD. In this scenario, the investor will earn $752.50 of interest over the term of the CD (18 months).
But what happens if during that 18 month term rates rise? The entire $50,000 balance is unavailable to be invested at the now higher interest rate. The investor will have to make a decision: Pay the early withdrawal penalty and reinvest at the higher rate (in some cases this might be financially beneficial) or hope that interest rates stay high until the current 18 month CD matures.
I would propose to this investor that there is a better way. Laddering. By laddering your CD investment, the investor can take advantage of higher CD rates in longer maturity terms at current offering rates and reduce the exposure to interest rate risk over time.
For example, if the investor chose to place $25,000 in a 12 month CD offering a 0.50% APY and placed the remaining $25,000 in a 60 month CD offering a 1.70% APY, the investor would earn a total return over the same 18 month period of $828.93, a $76.43 increase from the first scenario. In addition to an increase in the total return, the investor has exposed half the total investment to less interest rate risk. If rates rise in the short term, the investor will have the ability to reinvest half of the total investment at a higher rate, increasing total return on investment and the added benefit of increased liquidity with funds coming available more frequently if needed.
While achieving that “perfect” investment opportunity may be a fantasy, this is one option to achieve 2 of the 3 factors (low risk and liquidity) while achieving a better overall return on your investment.
Has your banker discussed CD laddering with you?
VisionBank. See what we can do for you.
*CD rates in this article are hypothetical and not a prediction or offering of future rates or earnings.
Mike Philips is the Senior Vice President of Retail Banking at VisionBank