For many years, Americans have experienced an unprecedentedly low-interest rate environment. Winners during this period included nearly all borrowers, as mortgages and other financing instruments were essentially on sale. Interest rate increases imposed by the Federal Reserve (FED) over the past year have been “in your face,” both numerous and substantial. Borrowers with variable-rate loans, potential homeowners, people with credit card debt, etc., all have been impacted by frequent and harsh rate elevations.
Losers in our prior low-rate environment included many savers, who watched their fixed-income investment yields nearly evaporate. Money Market Funds, CDs, and Bond Funds were largely shunned for lack of monetary returns. Hit hardest were older savers seeking to protect their principal, while receiving supplemental income. These people are becoming today’s winners, having been presented with income opportunities not seen in many years.
For today’s discussion, we will concentrate on the familiar Certificate of Deposit, or CD. Short-term investments (less than 5 years) can now be safely invested, with CD yields in excess of 4%. Perhaps not show-stopping rates, but compared to former pathetic yields, these new rates constitute a virtual windfall. In our financial advising and investing business, we are currently purchasing CDs for clients, and deployed idle cash into rewarding assets. But not every opportunity is a “no-brainer.”
Laddering refers to the practice of dividing income investments (CDs, Bonds, or even annuities) into units with staggered purchase and maturity dates. Laddering is meant to take advantage of varying interest rates, which normally increase with additional time to maturity. While rates are not yet aligned in a normal fashion (the yield curve is inverted), excellent opportunities exist in the 1 to 3-year range. Many investors are accustomed to renewing their income investments as maturity dates are reached. In a rising rate environment, renewal rates are generally superior to expiring rates.
Most people understand that surrendering a CD early carries a financial penalty, typically two or three months of interest. What may not be intuitive is the number of actual dollars involved in surrendering low-interest-rate CDs. Assuming a 1% CD yield for $100,000, quarterly interest is only $250. Replacing the CD with a 4.5% yield pays a quarterly rate of $1,125, for a net gain of $875 quarterly. For a common penalty of 3 months’ interest, the net gain is well worth the process of surrendering the unexpired CD.
If you currently own any CDs with time remaining to maturity, this is an opportune moment to exercise some creativity by evaluating the costs and benefits of an early surrender.
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