Saving

Finding Higher Yields In Unlikely Places

photo: Dazzie D

Bank CDs are about as exciting as Perry Como CDs. You put some money in. Wait a year, or two, or five. At the end, you get your money back, plus a little interest. It’s like the world’s slowest, least-risky slot machine. If you want your money back before the CD matures, of course, you’re out of luck.

Or are you?

A number of financial bloggers and mainstream news outlets have recently noticed something: the early withdrawal penalties charged on long-term CDs are puny. They’re more of a slap on the wrist than a pound of flesh.

Take the ten-year CD from Discover Bank, for example. It currently pays 3.25% APY and charges a penalty of nine months’ interest. If you held it for two years and then cashed it out, it would yield an APY of 2.08% after accounting for the penalty. The best 2-year CD rate in the country currently pays 1.76%.

Rarely is anything in the investment world so black-and-white: nobody should buy a 2-year CD. If you want a 2-year (or 3-year, or, even 1-year) CD, buy a long-term CD and cash it out.

I learned about this idea from the blog of Allan Roth, a CPA and author of the book How a Second-Grader Beats Wall Street. It’s nothing new; Roth first wrote about it over five years ago. “I had a contact at Capital One in the chairman’s office,” said Roth, “and I brought it up to them, I wrote about it, and lo and behold, about a month later, I noticed they had changed their early withdrawal penalty.”

I initially dismissed this is a sneaky trick, but now I’m convinced: nearly everybody who has cash in savings should be storing some of it in a long-term CD.

Be careful out there

Investors are looking for safety. They’re gobbling up US treasury bonds, which are paying historically low rates of interest. The 5-year treasury bond yielded 1.51% as of September 13, 2010.

Meanwhile, a few days ago I bought a 5-year CD from Ally Bank. It has an APY of 2.74% and a penalty of two months’ interest. “That’s near cash,” said Roth. “If you need the money back in two months, you net zero, which is about what you’re getting in your money market.” I put most of my emergency fund into the CD; it had been sitting in a savings account (SmartyPig.com) earning 1.75%.

Wait, though, is my CD as safe as that government bond? No, it’s safer. Really.

Here’s why. The CD is FDIC-insured, making it just as safe as a treasury bond. If I want my money back before the five years are up, however, the CD is better, hands-down. If I want to break the CD, I pay a tiny penalty. If I want to get my money back on the bond early, I have to sell it. If interest rates go up, my bond will be worth less. I might end up losing principal. And all that on a bond that pays much less interest than my CD.

If you’ve accumulated enough savings to cover a few months’ worth of expenses, the way financial nerds are always telling you to do, some of it belongs in one of these CDs.

A bank backlash?

Surely I don’t have to convince you that there’s nothing unethical about breaking a CD. The rules are spelled out in the contract; it’s not like you’re blowtorching your way into the bank vault. But Roth already spooked one bank. Are other banks going to wise up and demand more punitive penalties?

“This isn’t the first time the banks have been to the rodeo,” said Greg McBride, senior analyst at Bankrate.

So far, though, breaking a CD is still cheap. Roth chalks that up to inertia. “The penalty’s always been one year, nine months, et cetera,” he said. To you and me, changing the penalty on a CD sounds like a no-brainer. To a banker, it’s a wild and crazy new idea.

Ally’s low penalty was called out in the New York Times in June. “Nothing has changed,” Ally spokesman Travis Parman told me. “Of course, the intent is not to have somebody take one of those long-term CDs and cash it out early.”

Aside from inertia, banks know that most people don’t break CDs, and the banks need long-term deposits. “Right now, consumers have a real preference for liquid investments, like savings accounts and money market deposit accounts,” said McBride.

Data from the Federal Reserve bears this out. In March 2009, American banks held $1.4 trillion in CDs. Since then, customers have moved about $400 billion out of CDs and into savings accounts. The banks would love it if you’d loan them some money for five years at 2.74%, in case interest rates go up, and they don’t want to scare you off with onerous terms and conditions. “I suspect they are clearly aware of what they’re doing,” said Roth.

But for you, the person with money in a savings account or money market fund earning peanuts today, the debate over what might happen next year is irrelevant. A bank can’t change the terms on a CD you’ve already bought. Maybe this trick will work in the future or maybe it won’t, but you can profit from it today.

Fine print

This is the closest thing I’ve ever seen to a financial free lunch. But there are, inevitably, a couple of red flags to watch out for:

1. Check and double-check the early withdrawal penalty on the CD.

Some banks do charge high penalties. Anything over six months on a 5-year CD or 12 months on a 10-year CD is probably too much.

2. Don’t buy brokered CDs.

“Make sure you’re dealing directly with the bank that’s offering the CD,” said McBride. You can’t make an early withdrawal from a brokered CD. You can only sell it—possibly for much less than you paid for it. If you buy your CD on a bank’s (not a brokerage’s) web site, you’ll be fine.

3. Some CDs let you make partial early withdrawals.

If you have a small emergency, say, you could withdraw $1,000 from a $10,000 Discover Bank CD and pay the penalty on only the $1,000. That is not the case with Ally Bank, where any early withdrawal dissolves the CD. However, Ally has no minimum deposit. Instead of opening a single $10,000 CD, you could open four $2,500 CDs. All it takes is a few extra keystrokes.

4. Worst-case scenario…

If a bank is taken over by the FDIC, the bank that buys your bank can lower the rate on your CD. If this happens, you can withdraw the full amount (including any accrued interest) with no penalty. This doesn’t happen often, but like everything that doesn’t happen often, it happened a lot in 2008 and 2009.

So, you see, the humble Certificate of Deposit is more exciting than you thought. Hmm. I wonder what happens if I play this Perry Como record backwards?