Are Certificate of Deposits (CDs) worth it?

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:

Results Summary
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
\$10,000.00
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.

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10 Responses to Are Certificate of Deposits (CDs) worth it?

1. MasterPo says:

Most CD’s can be broken in an emergency if you need the cash. Otherwise being locked up does reduce the temptation to spend it.

I sure can use an extra \$125 anytime!

If \$125 is too little for you to be bothered with just send the check to me. I’ll send a nice Thank You card back.

2. My Journey says:

@Master Po,

I guess the first issue is…what is the definition of an emergency? Is it only for death or disability? What about unemployment?

The second issue would be who decides – I assume death is an easy one to decide, but what about unemployment? Voluntary vs. Unvoluntary; issues of are you looking hard enough for a new job, etc.?

That \$125 is before taxes. I will probably be around the 30% tax bracket. So that \$125 really turns into \$87.50.

I am still unconvinced that \$87.50 is worth the full use of my money, when I want, not some questionable banker (if that is in fact the person deciding what an “emergency is”).

3. MasterPo says:

MJ – “Emergency” to me is any large unforseen and unavoidable expense. It’s a subjective thing. But even with unemployment like I said you can break most CD’s if you desperately need the money. Certainly keep something in a more liquid account anyway. You know from your life style how much you would need right away in the event of unemployment. Keep some liquid and some in CD for that little extra.

I think you show a touch of bias with the “questionable banker” comment. I don’t want to argue the bank situation these days. But you are FDIC covered and you can always spread around your deposits (not all eggs in one basket). Besides, even with a demand/deposit style account the bank is still using your money and you have the same risk exposure. You just “feel” you can get access at a moment’s notice.

Never over look the small stuff. You say you’re a financial planner. I’m sure you have millionaire clients who argue the pennies. It all adds up in the long run.

4. My Journey says:

You misunderstood my quotations around questionable banker, and that is my fault. What I meant was a banker who has a direct pecuniary interest in whether your \$1,000 \$10,000 or \$100,000 remains locked up in a CD making the decision as to whether your need is an emergency. I didn’t mean to take a swipe at the banking industry as a whole.

Although I do have to say your fractional reserve statement is profound. You are correct, I FEEL like I can get to the money, but if it is not htere I can’t. Simple yet profound, I might do a post on that later on (or maybe you’d like to do a guest post). I would love to explore that more.

I think your point, and please let me know if I am incorrect, is diversification within guaranteed returns, and to that I will give you credit. However, I still can’t see myself locking the money up due to the lost opportunity cost.

It may seem like I am changing the game here, but if your money is locked up for 1 year, that great real estate deal, business opportunity, stock opportunity, etc., is not an emergency and you are going to get killed on fees. This leads me back to my point, is the extra \$125 (\$87.50 after taxes) worth the lost opportunity cost? In my humble opinion, I still think it is not worth it.

5. MasterPo says:

Where do I begin.

First, thanks for the kudos. I wasn’t trying to be profound but sometimes it just flows. 😉 I’d glad to to a guest post. Email me about it.

I agree about the opportunity loss. That’s part of the reason why I suggested not to lock all your money up in CD’s. You should always have some amount of liquidity. I don’t think there’s a set rule. Each person has to do what they feel comfortable with. You can also setup a ladder of CD maturities from say 3 to 12 months (I know you don’t like shorter term CD’s).

As for fees for breaking a CD, for example ING ‘charges’ 3 months interest as a penalty. So if you are at least 3 months into the CD at worse you break even. Small enough price to pay IMO if you really feel you need the cash immediately.

With bank interest rates as low as they are this is all probably a mute point in the short run anyway. The spread between a liquid vs. illiquid account is very small in most cases. Barely .25%. If the spread was greater or the chances of rates dropping a lot more I’d say locking up money for 12 months+ is a good move (wish I had opened more 5+ year CDs a couple of years ago!).

But always keep liquid anyway. There are worse things.

I agree with MasterPo. It all depends on what that money is “for”. If we are talking a short term savings account (for a vacation, for example, or to park funds waiting for some planned disbursement like an annual tax bill), then the modest difference in the interest rate probably won’t matter to you.

I, however, WANT part of my emergency fund somewhere there is a penalty if I pull it out. I know myself. I have a tendency to ‘fudge’ what actually consitutes an emergency. It’s part of fiscal self discipline to me to have my ‘lost my job’ fund in laddered CDs, while the ‘auto ins deductible’ and ‘washing machine blew up’ parts of the e-fund are in an online yield savings account with three day access.

Any funds that are any ‘closer’ WILL get spent. I’m still working on that part of my fiscal discipline LOL.

7. My Journey says:

Karla,

That is a whole different issue, one that I absolutely understand. I purposefully have more money going into my ING account (3%) vs my WAMU High yield savings (3.75%) because it provides a barrier to spending.

While I understand that, and if that is your reasoning RUN WITH IT! Just be aware why you are doing it…it is the same situation as the debt snowball vs debt avalanche widely debated all over PF Blogs, do what works for ya!

8. appfunds says:

What about your bank going bankrupt. Do you consider it or no?

9. My Journey says:

appfunds,

I am sure everyone worries about their bank going bankrupt, but after thinking about it for a little while (and after calming the wife down since we mainly use Wamu) I decided it wasn’t necessary to freak out.

I have no where near the FDIC limits and I have faith in our country and banking system to where I would be made whole.

10. tinogut says:

I am getting unemployment benefits at present, but I need extra money to pay off some hot loans. Will I lose my benefits if I cash in a CD to make ends meet?