Game the system with 10-year CDs?

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I wrote a few months ago about 10-year certificates of deposit being, in general, a really bad deal. And that’s true, as long as you intend to hold the CD to maturity.

But Allan Roth of CBS MoneyWatch has been writing about a CD investing strategy for a while that may allow CD investors to use long-term CDs to game the system. By buying a long-term CD to get a better rate, with the assumption you’ll dump it (and eat the early withdrawal penalty) as soon as CD rates rise, you may be able to get a higher return overall than you would with shorter maturities.

For instance, say the highest CD rate you can find on a three-year CD is 1.25 percent, but you find a 10-year CD paying 2 percent with an early withdrawal penalty of nine months of simple interest. You decide to open a $100,000, 10-year CD, with the understanding that you’ll cash it out in three years and eat the CD early withdrawal penalty.

Assuming you spend the CD interest payments instead of reinvesting them, you’ll clear $4,500 in total interest, $750 more than on a three-year CD.

Three-year CD at 1.25 percent 10-year CD at 2 percent
Total interest after 3 years $3,750 $6,000
Early withdrawal penalty $0 $1,500
Total interest received $3,750 $4,500

Additionally, if rates happen to stay at rock bottom, you can always hold on to the 10-year CD and continue enjoying higher CD yields until things change.

It’s worth noting that neither regulators nor banks would be happy to see this practice become popular. Long-term CDs pay more because banks are assuming they’ll be able to hold on to your money for a longer time, and regulators want CDs to be illiquid so they can provide a stable source of funding for banks. But by imposing relatively small early withdrawal penalties, many banks have undermined that illiquidity. Some financial institutions charge as little as 30 days in interest to close out a CD early.

Banks may be waking up to that fact. In Bankrate’s 2012 CD early withdrawal penalty survey, almost all banks reported being willing to dip into a CD’s principal rather than just confiscating interest to satisfy a penalty. Penalties at many large banks have increased as well, with some creeping as high as 3 percent of the withdrawn amount, plus $25, which would be enough to derail this strategy.

And there are some major caveats to keep in mind before putting your money on the line here. You’ll want to very carefully review the deposit account agreement before trying something like this, and be sure you do the math to figure out how long you’ll need to hold on to the funds to make it worthwhile. Missing a few words can mean the difference between netting extra money and losing big.

Also, it’s possible the financial institution in question could find a way to turn the tables on you. A few credit unions have tried increasing early withdrawal penalties on existing CDs, and it’s possible that regulators could allow them to do so.

What do you think? Have you ever tried this strategy? What was your experience?

Follow me on Twitter: @ClaesBell