I can’t be the only one out there, but I can’t grasp why people would do invest/purchase a Certificate of Deposit (CD). Specifically, I am focusing on the 1 year CD because anything shorter has terrible yields and anything longer poses too much of an interest rate risk for my tastes. I started thinking about this topic when I saw a Wall Street Journal Blog entry titled, “Banks Offer Higher CD Rates to Offset Credit Crunch Losses” discussing how the big banks are starting to raise CD interest rates. Specifically, it highlights Washington Mutual’s 5% APY 1 year CD.
What is a Certificate of Deposit (CD)?
The Securities and Exchange Commission provides us a straightforward definition of a CD,
A CD is a special type of deposit account with a bank or thrift institution that typically offers a higher rate of interest than a regular savings account.
When you purchase a CD, you invest a fixed sum of money for fixed period of time – six months, one year, five years, or more – and, in exchange, the issuing bank pays you interest, typically at regular intervals. When you cash in or redeem your CD, you receive the money you originally invested plus any accrued interest. But if you redeem your CD before it matures, you may have to pay an “early withdrawal” penalty or forfeit a portion of the interest you earned.
Math Against Certificate of Deposits
I thought a fair comparison would be $10,000 in Washington Mutual’s 5% APY 1 Year vs $10,000 in Washington Mutuals 3.75% APY online savings account. My hypothesis: The amount extra you will earn is not, in my humble opinion worth, your money being locked up for 1 year.
Using DinkyTown’s handy CD Calculator (I am sure I could have done this on Excel also) indicates the following:
Initial deposit $10,000.00 / Length of CD 1 year (12 months) / Interest rate 4.890% compound monthly / Total annual yield 5.001% / Annual Percentage Yield (APY) 5.001%
Ending balance $10,500.11
Certificate of Deposit Balances
Month Interest Balance
1 $40.75 $10,040.75
2 $40.92 $10,081.67
3 $41.08 $10,122.75
4 $41.25 $10,164.00
5 $41.42 $10,205.42
6 $41.59 $10,247.01
7 $41.76 $10,288.77
8 $41.93 $10,330.70
9 $42.10 $10,372.80
10 $42.27 $10,415.07
11 $42.44 $10,457.51
12 $42.60 $10,500.11
Do not get me wrong – 5% in an FDIC insured account is great! Especially in this market, however, compare this investment vehicle to Wamu’s 3.75% online savings account.
Annual Percentage Yield (APY) Total Return / Monthly compounding: 3.753%
Initial deposit $10,000.00 - Ending balance $10,375.31
Analysis of CDs
Our estimated end results are $10,375 vs $10,500 – a difference of $125.00 BEFORE TAXES! Not sure about you, but I wouldn’t tie up my $10,000 for $125 extra. Heck, even if I had $100,000 extra I wouldn’t purchase a CD for an extra $1,250 before taxes.