Buying A Bank CD
Copyright 2009 by Morris Rosenthal - - contact info
Copyright 2009 by Morris Rosenthal
All Rights Reserved
Certificate of Deposit Purchase, Renewal and Interest Penalty to Break CDs
Buying CDs can be a great investment in times of inflation. Back in the late 1970's, CD interest rates went into double digits, and my old business partner used to chase around town for his mother, who kept all her savings in CDs, and who bought into longer terms as interest rates finally began to fall with inflation. But there are many different CD (Certificate of Deposit) products offered by banks, and the terms and conditions can turn a good savings plan into a bad investment should you need the money before you planned, or miss the grace period on a certificate that is automatically renewed. The banks play a very sleazy game with CD rates on auto renewals, as near as I can tell, it's the sole reason they feature higher interest rates on different CD terms on a regular basis. During the summer, it may be the seven month and thirteen month CDs paying the highest interest, during the winter it could be the six month and the twelve month. Don't even get me started on spring and fall. By rotating the best paying interest rate CDs, they can catch the maximum number of people who get rotated into a bad CD rate if they fail to get to the bank and cancel the new CD during the grace period.
In May of 2007, I bought a thirteen month CD with a 5.5% interest rate, my best investment of the year:-) For some reason, I thought I bought it in June, so I only got around to checking the CD through my online banking access a week into June. It turned out the CD had automatically renewed on June 2nd, 2008, and I only noticed on the evening of June 10th. I was at the bank bright and early on the next day to cancel the automatic renewal, the last or second to last day of the ten calendar day grace period, depending how they count. Some nasty banks only give a seven day grace period, for which I would have been too late. And the cost had I missed? My 5.5% CD autorenewed at 1.6%. Yes, interest rates are down this year, but the bank was selling twelve month CDs at 3.0% the day I was there. And the automatic renewals put you into another cycle of the same length as the previous CD, so I would have been locked in for thirteen months at 1.6%.
Once caught in the automatic renewal trap, you can break the CD, but it may not make financial sense. CD's with terms less than a year usually carry a three month interest penalty, over a year is normally a six month penalty. A six month interest penalty of a thirteen month CD is practically half of the value of the earned interest, and would have knocked my 5.5% rate down to around 3%. On the other hand, you can grit your teeth and stay in the new CD until three or six months have elapsed and then break it, which means letting the bank use your money for free for the interest penalty period. The decision whether or not to break a CD, whether a long term CD that you bought intentionally or a CD that you accidentally own through automatic renewal, depends on what you can do with the money once it's back in your bank account. If you own a multi-year CD at a very low interest rate, and you get the opportunity to buy a CD at a much higher interest rate, just do the math comparing the earned interest on the life of the original CD if you kept it, vs the earned interest on the original CD, minus the penalty, plus the interest you'd earn on the new CD. And tweak the math if the penalty amount is tax deductible, though the impact of that depends on your overall tax status.
Regular bank CDs are insured along with the rest of your deposits to $100,000 per bank. There's nothing to make CD's inherently safer than deposits in your checking or savings account, it's all a promise by the bank to pay you. But if you are talking about a money market account or a money market CD, there is a small amount of risk to the principal amount, even if the value of the account is under the $100,000 FDIC insurance. The insurance on a money market account protects you against the bank going bankrupt, but it doesn't guaranty the value of the money market. Money market products are structured as shares in a money lending pool, with a nominal value of a dollar, against which the interest is computed. If things go wrong with the loans or the liquidity of the bank, they may "break the dollar" and the value of the dollar denominated money market accounts and CDs will fall by some amount. It hasn't happened in so long that nobody thinks much about it, though there were rumors this past winter about giant banks and brokerages being on the verge of breaking the dollar, it didn't happen. Any reputable financial institution would rather take a major loss than lose the confidence in their products that would come with breaking the dollar. Another other option for fixed rate interest savings that carry no risk at all (excepting inflation or the failure of the government) are T-bills.
You can also buy IRA CDs, that are treated like separate IRA accounts, or buy CD's for your brokerage IRA account if they are set up for it. People usually go for the longer terms on an IRA CD because the money is being saved for the long term, and you have worse penalties than interest if you decide to take the money out before retirement age. On the whole, I'm puzzled why bank play such a crooks game with CD rates. If I had been two days later and failed to cancel the automatic renewal of my CD, it would have meant the end of my dealings with the bank, where I have three separate accounts. I would have pulled out all the money and gone elsewhere, because while I don't mind making mistakes, I hate being played for a sucker. You'd think that customers would be valuable enough to banks to not play us for the short term, but as the mortgage debacle has taught us, that's all that banks are really into these day.
This guide is in progress, and I welcome your comments, questions and suggestions