Interest rates have risen substantially the last nine months. While rising rates are bad news for bond and bond fund investors, rising rates are good news for certificate of deposit and Treasury bill investors because renewal rates are higher.
According to USA Today, the average one-year CD is yielding around 4.4 percent, and five-year CDs are paying closer to 5.7 percent. Treasury securities are even better, with one-year T-bills yielding 5.8 percent and five-year T-notes over 7 percent. Six months ago, the yields were much lower. One-year CDs were at 3.2 percent, and five-year CDs were at 4.7 percent. Treasuries were at 4.3 and 5.8 percent, respectively, six months ago.Some of you may have been forced to lock up your money for longer maturities than you normally would because interest rates were so low. Many savers stretched their maturities out to capture higher yields. Now that interest rates are higher, many CD investors are sorry that they locked their money up for so long at such low rates.
PENALTIES TO GET OUT EARLY. Most CDs have penalties for withdrawal before maturity. While each bank is different, a general guideline to use for early withdrawal penalities are one month's interest on three month CDs, three months' interest on six month CDs, and six months' interest penalty on CDs of one year or more.
Until 1986, early withdrawal penalties were regulated, but today, policies vary from bank to bank. In fact, some banks don't charge any penalty at all. According to The American Bankers Association, over 1,300 banks charge no penalty at all for early withdrawal.
IT SOMETIMES PAYS TO PAY. The recent rise in interest rates has been swift and substantial. Depending upon your circumstances, it may be worth your while to cash in a low-yielding CD, pay the early withdrawal penalty and reinvest it at a higher rate.
Let's say you purchased a $25,000 five-year CD six months ago at 5.7 percent. You would earn $1,425 a year in interest, which computes out to an additional $6,412 over the remaining 41/2 years of the CD. You would have to pay a $712 penalty to prematurely cash it in. Would it make sense to pay the
penalty? Assuming you were bright enough to recognize that Treasury securities were a far superior deal to bank CDs, you could roll your $24,288 ($25,000 minus $712 penalty) into a five-year T-note at 7.1 percent. Your annual interest earnings on the T-note would be $1,724, or $7,758 over the next 41/2 years.
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Outlook, 49, free sample, 442-9000
YOU'D BE BETTER OFF. You'd be earning almost $25 a month more from the T-note, so it would take you approximately 28 months to break even. After that, you'd be money ahead. Overall, you would earn an extra $638 over the next 41/2 years, even with the $712 penalty. Sometimes, it makes sense to accept a penalty.
This computation doesn't even take into account two big tax benefits. One, the interest earnings from the T-note are exempt from state and local taxes. Depending upon which state you reside, this tax savings can be significant. CD earnings, however, are 100 percent taxable on both the federal and state
level. Furthermore, early withdrawal penalties are tax deducatable, so the IRS will subsidize your penalty. If you are in the 28 percent tax bracket, the cost of the $712 penalty drops to only $513, after tax.
CHECK YOUR PENALTY. Earlier I mentioned that penalties differ from bank to bank. You can't do the math without first knowing exactly what it's going to cost you to prematurely cash in a CD. Don't forget that many banks will often waive early withdrawal penalities in the event of death, medical emergency or other unusual circumstances. Some bankers do have hearts.
It isn't often that paying penalties make sense. The time when it does is when interest rates rise substantially and do so over a fairly short period of time, which is exactly what the last 10 months have been. Millions of CD buyers should be evaluating the viability of this swap technique.
If you are stuck with a long-term CD that locked into a uncompetitive rate, do your homework, crunch the numbers and see if it pays to cash in early. The answer might surprise you.
Whatever you do, don't take out another CD. The yield spread between CDs and Treasury securities is extremely wide, and only the naive are neglecting the juicy yields our government is offering. If you don't know how to buy Treasuries, you should order the brochure "Buying Treasury Securities." The cost is $4.50 (makes checks payable to Federal Reserve Bank of Richmond), and the brochure is available by mail at P.O. Box 27471, Richmond, VA 23261.
Buying Treasuries direct is a piece of cake. You can purchase them either from a Federal Reserve Bank branch or by mail. Treasuries that mature in less than one year require a minimum investment of $10,000, two-year Treasuries have a $5,000 minimum and five and 10-year Treasuries have a $1,000 minimum. You can always buy them through a bank or broker, but you will pay a small commission of $20 to $75.