5-year CD may not be the answer

You'd be sorry if rates later rose, or if you needed the cash sooner

April 15, 2001|By Jeff Brown | Jeff Brown,KNIGHT RIDDER/TRIBUNE

My wife and I are entering a retirement community. The sale of our home will cover the entrance charges, and Social Security and pensions will cover the monthly fees. We have $60,000 in one-year CDs that will mature in July. Would it make sense to reinvest the proceeds in five-year CDs to get a higher interest rate?

Opting for a certificate of deposit with a longer term may not pay off as well as it has at other times.

Typically, CDs with longer terms pay higher rates than CDs with short terms, since investors demand higher yields for taking the greater risk of tying money up longer.

The longer the period, the greater the chance interest rates or inflation will rise during the term, making you regret that your money is tied up in an older bond or CD with a low yield. Short-term rates are heavily influenced by the Federal Reserve. Although the Fed has been cutting short-term rates this year, these rates are still not as low as they have been at other times.

Meanwhile, long-term rates, which are determined by supply and demand as investors buy and sell bonds, have fallen considerably as investors look at the weakening economy and bet on what rates will do in the future.

All of which boils down to this: The typical one-year CD yields 4.84 percent, while the five-year CD yields 5.07 percent.

In other words, you won't earn much more in exchange for tying your money up for five years. Putting $60,000 into average five-year CDs, you'd earn $3,042 per year. With the average one-year CD, you'd get $2,904 - just $138 less.

Here are some things to consider:

Penalties. Suppose you buy five-year CDs and need your money sooner? Many CDs have early withdrawal penalties equal to six months' interest. With $60,000 in five-year CDs, that would be $1,521.

Odds that rates fall. If prevailing rates were to fall over the next five years, you'd be glad you'd locked in to five years of earnings at over 5 percent. But the odds that rates will go lower and stay that way are slim. Rates on five-year bonds have been lower than today's level for only about five of the past 120 months.

Risk of rising rates. If rates were to rise substantially, you'd be sorry you'd locked into a five-year CD at today's low rate. You'd be better off with a succession of one-year CDs that would allow you to reinvest at higher yields without facing an early withdrawal penalty.

Inflation risk. Rising inflation usually coincides with rising interest rates. The higher the inflation, the less buying power you get out of your CD earnings. Inflation is still relatively low these days. If it picks up, interest rates would probably go up too, and you'd want to be free to buy new CDs paying more.

Reaching for the highest possible yield appeals to our competitive spirit. But, as you see, a fraction of a percentage point makes little difference in annual earnings in actual dollars.

So I'd go with the one-year CD instead of the five-year. But I would look for a one-year CD with a top yield. These days, there's no reason to limit your search to nearby banks; many CDs are marketed nationally.

Take a look at the free Web site for Bankrate.com, the rate-surveying company. It lists some one-year CDs paying nearly 5.5 percent. The site is http://www.bankrate.com. Bankrate's printed report, 100 Highest Yields, can be purchased for $25 by calling 1-800-243-7720, ext. 274.

Some Internet-based banks can afford to offer higher rates because they don't need to pay for branch offices.

And you might find a good deal at an old-fashioned bricks-and mortar bank, too. A bank may raise its rates to lure more deposits, so it will have more money to lend.

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