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Locking in Long Term CDs in a Low Rate Environment

Written by Nickel - 13 Comments

Interest rates are very, very low right now. On top of that, the first “rung” on our CD ladder is coming up for renewal next week. We should be rolling that money into a new five year CD, but is that a good idea given current CD rates?

When we first started our CD ladder (Novemeber 2008), we bought a one, two, three, four, and five year CD. Rates topped at out 5.15% for the five year CD, and our overall average was 4.66%.

Fast forward to today… We’re now looking at 3.35% APY for a five year CD at the same bank — nearly 2% lower. On the surface, we should probably run away kicking an screaming, but when you dig deeper, the situation isn’t too bad.

If we roll that lowest rung into a new five year CD, the average rate will dip to a bit under 4.50%, which still isn’t too shabby. The big concern, of course, is that interest rates will spike and we’ll be locked in at a low rate. Then again, we can escape with “just” a six month interest rate penalty.

In other words, if we can hang on for a year or so, our effective interest rate would be roughly half the current rate (around 1.70%). If we make it for 18 months, we’d take home 2/3 (just under 2.25%), and so on.

When viewed in that context, the situation isn’t nearly so bleak. If rates jump, we can simply break the CD and re-deploy our cash. Sure, we’ll give up some interest earnings, but our money will still have performed on par with prevailing high yield savings rates, so we’re not risking much.

Published on October 29th, 2009 - 13 Comments
Filed under: Banking, Saving & Investing

About the author: is the founder and editor-in-chief of this site. He's a thirty-something family man who has been writing about personal finance since 2005, and guess what? He's on Twitter!

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13 Responses to “Locking in Long Term CDs in a Low Rate Environment”

  1. 1
    Financial Samurai Says:

    I have VERY strong opinions about this Nickel. It doesn’t matter how low the interest rates are, b/c the yields are generally baking in inflation.

    One should ALWAYS put money in the longest duration, highest yielding CD, which is usually 5 years. This is for money you don’t need, and never plan to touch until retirement or after anyway.

    It’s what I call the “DVD Method To CD Investing.” I wrote an entire article about it, and it has literally made me an extra $10,000-17,000 a year for the past 8 years using this strategy. It has been a big boon.



  2. 2
    John DeFlumeri Jr Says:

    Do we want to lock in right now? Aren’t rates gonna go up soon anyway?

  3. 3
    Kevin Cafferty Says:

    Here’s hoping rates come back up by the time your intial 5-year CD comes up for re-investing!

  4. 4
    Philip Lowman Says:

    Rather than “hanging on a year or so” and hoping for a 1.70% return (after paying penalties), why not just buy a one year CD at 2.00% and reevaluate your options 12 months from now? Interest rates will likely have risen by then. Sure, this “breaks” your CD ladder but you can always “repair” it later.

  5. 5
    Hank Says:

    I agree with Philip. Why go through the hassle and penalties of breaking a 5-year CD? By the time you pay penalties, etc. you would have just earned what you would have with the 1-year to start with. Why not just stick with a shorter term maturity until interest rates begin to rise again?

  6. 6
    Financial Samurai Says:

    Thanks Kevin. If you employ my CD strategy, the 5-yr money comes due every year so you are always liquid.

    Rates have gone down for 30 years in a row, what makes you think suddenly rates jack up despite all the monetary pump priming?

  7. 7
    Nickel Says:

    There’s actually minimal hassle involved with breaking a CD. It’s really no more work than changing the term of one year CD when it comes up for renewal, so there’s not much difference between the two alternatives.

  8. 8
    BG Says:

    Long term CDs look great (in hindsight) in a falling rate market. They don’t look so good in a rising market. Your ladder is averaging 4.6% right now, which is great when the going rate is 3.3%. But if you reverse the numbers, would you really want to average 3.3% in a 4.6% market?

    I agree with your strategy, bust any CD yielding less than today’s going rate (after calculating the break-even points in regards to the penalty) — why hold onto an under-performing asset in a rising market?

    Personally, I look at my debts as well (5% mortgage) so I’d be putting new money against that instead of buying a 3.3% CD — but have a sizable emergency fund before doing any “investing” (e-fund can be a CD ladder, don’t really care about the rates in the e-fund).

  9. 9
    Nickel Says:

    BG: Of course, as rights rise, you’ll be locking in a higher rate for each rung on a yearly basis. While it’s possible that rates could spike, the fact that we can simply break the underperformers and re-invest makes this risk much easier to swallow.

  10. 10
    LB Says:

    Hi, I am retired and put my lump sum in 5 laddered CDs – 1, 2, 3, 4 and 5 years. My IRA has about an equal amount in mutual funds. I still have a mortgage – 250k. My first CD has matured. Do you think I should put this money in the mortgage? Or in mutual funds? Or in another CD – 5 years out? Thanks.

  11. 11
    BG Says:

    LB) What was your original plan when you started the CD ladder? You knew that these CDs were going to start maturing eventually and must’ve had a plan when you started the ladder.

    Only you can really judge your financial situation and make the best possible moves. If you are contemplating changing from your old plan and do something else, try to understand why you want to change plans now: has something changed financially for you?

    For me, making this sort of decision (in retirement) would boil down to cashflow, and ensuring that you have the cashflow you need for both the short-term, as well as the long-term horizons and trying to find a suitable balance.

    If you are not sure that you will eventually pay the mortgage off completely, I’d probably not pay anything extra on it (while in retirement), since you will always have that monthly mortgage payment regardless.

    Nickel) I’m agreeing with others on here, that in a rising CD market (if one could even predict it), you want to buy short-term CDs, and avoid the hassle of penalties. In a falling CD market, opt for the longest terms you can find to lock in the high rates.

    The goal being, in a rising-rate CD market, you strive to have your CDs earning close to the average rate (utilizing short-term CDs). In a falling market, you strive to earn an above-average rate (utilizing long-term CDs).

  12. 12
    Nickel Says:

    “in a rising CD market… if one could even predict it”

    Aye, there’s the rub. Although rates are low, they’re actually still dropping — in the past two weeks, Ally has adjusted their rates down by 0.05% on two separate occasions. Other banks are (generally) in the same boat — still dropping or, at best, perfectly flat.

    So… I agree with you that, if rates were rising, I should go short. But they’re not. While they will eventually rise again (they always do), when that will start is anybody’s guess.

    When you combine the unknown landscape with the relative ease of breaking and re-deploying, I would argue that locking in the longer term is the smarter move (unless you have a better use for the money).

  13. 13
    Michael Harr @ TodayForward.com Says:

    @Nickel – Stay the course with your strategy. The 5 year ladder is part of a long-term strategy that will ultimately bring you a higher net return. Having worked in banking I can tell you that the most common mistakes CD investors make are chasing short-term yields and trying to predict the direction of interest rates. I seem to recall cash equivalents in Japan in a similar state many years ago and guess what? They stayed low for a long time even after mass injections of fiscal spending and loose monetary policy.

    It is impossible to predict rate movements. While it’s easy to figure out that we’re on the low end of the spectrum, we still haven’t a clue as to exactly when rates will move higher.

    Beyond this, CDs are a different animal than bonds. Because you don’t have movement in the principle as the CDs we’re discussing aren’t traded on the open market and instead have only an early withdrawal penalty, there is significantly less risk to employing a longer maturity ladder. Heck, 5 years is still towards the short-end in bond terms.

    By the way, did you see Australia’s latest bond auction? Rates don’t look too bad over there.

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