How to lock in higher CD rates

Don TaylorQuestionDear Dr. Don,
In regard to locking in CD rates for the long term at current rates, would it not be better to have a better rate at long term with a minimal penalty than a short term with a lower rate?
-- Lary Long-Term

AnswerDear Lary,
There are a couple of ways to look at what you're proposing. The first is a decision to ride the yield curve. That means that you invest in a CD with a final maturity longer than your investment horizon, and capture a net yield (after penalty) greater than the yield on a CD with a maturity equal to your investment horizon.

A yield curve, for the uninitiated, is simply a graph of yields over varying maturities for a specific risk class of investments. A CD yield curve is shown below.

CD yield curve
CD yield curve

The above curve is based on the highest yields reported by Bankrate on the day the graph was produced.

Key in this approach, besides the early withdrawal penalty, is your investment horizon. Riding the yield curve has you investing beyond your investment horizon, but redeeming the CD when you reach your horizon. If you have a two-year investment horizon and invest in a five-year CD, you expect the yield, net of the early withdrawal penalty, to be greater than today's yield on a two-year CD.

The second way to look at what you're proposing is that you invest out to your investment horizon and, if rates head higher over time, then you redeem your CD and reinvest the proceeds, net of penalty, in a CD out to your investment horizon. Because the yield curve is normally upward sloping, this can be a little hard to pull off.

Let's say your investment horizon is five years. You buy the five-year CD and two years out, rates have moved higher and you want to consider redeeming the original investment and reinvesting in a three-year CD. For this to work to your advantage, two years from now the three-year rate has to be above the original five-year rate, plus the early withdrawal penalty, expressed as a yield.

The third case is where you don't have a defined investment horizon and you're trying to maximize the yield over time. Perhaps you're in a situation where you don't want to touch principal and are living on the interest income. I'd argue that a laddered CD portfolio would be a better approach than your early redemption policy, but it's hard to prove the point without investment parameters.

I'd suggest taking a look at the 2010 Bankrate Survey on CD withdrawals to get a better handle on what's normal and customary in early withdrawal penalties before deciding to invest in longer term CDs.

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