- advertisement -

Trading CD could be good idea

Dear Dr. Don,
Is there a calculator I can access at Bankrate for the following situation? A CD I own earns 3 percent and has one year till maturity. Another bank has a 4 percent CD with three-year lock in. The bank with the 3-percent CD has a three-month interest penalty. Should I take the penalty and switch or stay pat? Thank you.
--John Judicious

- advertisement -

Dear John,
Bankrate has a host of certificate of deposit, or CD, calculators, but doesn't have one that tells you whether you should take the penalty, cash in your old CD and lock into a new CD. It's not a straightforward problem when you change the investment horizon, like you did in your question, from one year to three years.

Let's look at the apples to apples situation first. If you were trying to decide whether to redeem a 3 percent CD with a year remaining until it matures, and the CD has a three-month interest penalty on early redemption, then you're losing 3/12 x 3 percent or 0.75 percent interest on your current CD. For you to be ahead, you need to earn more than 3.75 percent on a one-year CD. Searching the 100 top CD rates using Bankrate's highest yields function you can currently earn 4.58 percent annual percentage yield on a one-year CD. That's higher than 3.75 percent, so you can benefit from redeeming the old CD and replacing it with the new CD without shifting your investment horizon.

When you shift your investment horizon from one year to three, you also have to consider what interest rates will be like a year from now when you can invest in a two-year CD without paying the early-redemption penalty on your now-matured CD. If interest rates have moved higher, you could be better off for having waited the year, not paid the penalty and then invested in a two-year CD.

It's not technically accurate, but you can use average annual rates to approximate where interest rates will have to be a year from now to be better off waiting to reinvest. Bankrate reports the highest yield three-year CD at an annual percentage yield of 4.71 percent. Here's a table that shows how you can use the sums and the averages to help you decide:

a
John's early redemption
Dr. Don's early redemption
Mature & reinvest
Year 1
(less 0.75% penalty)
3.25%
3.96%
3.00%
Year 2
4.00%
4.71%
5.19%
Year 3
4.00%
4.71%
5.19%
Sum
11.25%
13.38%
13.38%
Average:
3.75%
4.46%
4.46%

For you to be better off waiting to reinvest when the existing CD matures, you have to expect the two-year CD to yield more than 5.19 percent a year from now. While I can't tell you what two-year CD yields will be a year from now, you can currently invest in a two-year CD at a 4.64 annual percentage yield. So the rate on a two-year CD would have to increase by 0.55 percentage points over the next year for you to be better off waiting.

Bankrate.com's corrections policy-- Posted: Oct. 17, 2005
More Q&A stories from Dr. DonAsk a question
 RESOURCES
Emergency fund yields
Chasing higher CD rates
Early withdrawal can erase earnings
 TOP PERSONAL FINANCE STORIES
Video: 5 myths about going green
5 myths about going green
Video: Ways to keep produce fresh




CDs and Investments
Compare today's rates
NATIONAL OVERNIGHT AVERAGES
1 yr CD 0.95%
2 yr CD 1.16%
5 yr CD 1.71%
Mortgage calculator
See your FICO Score Range -- Free
How much money can you save in your 401(k) plan?
Which is better -- a rebate or special dealer financing?
VIEW MORE CALCULATORS
FINANCIAL LITERACY
Rev up your portfolio
with these tips and tricks.
- advertisement -
- advertisement -