Once a week I go yield hunting. I’m always looking for the best rates possible for my cash because I know that if I save X amount with a Y percentage yield, I’ll eventually reach my magical yearly cash flow number which will allow me to retire early if desired.
To get to your magical retirement number quicker, you can either save more or look for better returns. Currently 80% of my cash hoard is locked up in 5-7 year CD’s yielding on average 4%. The “problem” I currently have is that every year I work, is another year’s worth of savings I have to figure out what to do with it.
As you can see from my nifty CD banner to the right, I don’t have to look very far at all to keep track of what the best CD rates are in the entire country. The widget keeps track of all the rates for me and for all of you who visit this site regularly. I clicked on a Capital One 3% CD to see what it’s all about, and discovered it’s a 10-year CD! Doh….
DURATION, YIELD, AND DEATH AS IT PERTAINS TO CDs
Up until last year, I always assumed 7 years was the longest duration offered because that’s all I saw. Something changed this year where more and more financial institutions are offering 10 year yields. So what happened? Well, the markets happened and banks are being more opportunistic.
A bank’s main goal is to bring in deposits at the lowest rate possible and lend money out at a higher rate. This is called the “net interest margin.” As we have experienced during financial meltdowns, the stability of deposits is also important. No bank wants a bank run where suddenly every single customer wants their money back, and then the bank goes under because they have to recall their loans.
With long term CDs, banks are able to obtain relatively more stable money. As a yield hunter, I’m always going for the highest yield possible, generally at the longest duration possible. Because I work and save every year, it doesn’t matter if yields suddenly go up the very next year since I have a new chunk of change to plop down. You always want to employ the “DVD Method To CD Investing” by going after the longest duration possible to always get the maximum yield.
However, with the 10-year CD at only 3%, I’ve stopped to think whether this is a good idea or not.
Banks Are Generally Smart
By all historical standards, interest rates are low. Despite QE1, QE2 and massive monetary stimulus elsewhere, inflation is still relatively benign (so the government tells us). However, it is very logical to conclude that inflation, and therefore interest rates must go up based on a simple IS/LM chart and truism stating that every one dollar bill created leads to one dollar bill higher in prices.
As a result, banks are taking the view that if they can lock in 3% money for 10 years, they are in a winning position. Banks are taking the view that perhaps in years 3-5, they might have to pay 5-7% interest for similar duration CDs, thereby increase their funding costs and decreasing their net interest margins. If a bank could offer 3% yields for 20 years, I’m sure they probably would, but nobody would probably buy them!
Death Comes To Us All
With a 10 year duration, I think about death. Will I be alive in 10 years to collect on my principal without penalty? Hope so. Will inflation be higher in 5-10 years? Most likely yes. Do I need the money during this time frame if I continue to work and save? Most likely no.
What you need to do is think what the bank is thinking. With 10-year CD’s becoming more common place, it means that customers are demanding longer duration products because they don’t believe in inflation, and they are risk adverse. On the other hand, banks are probably thinking customers are lemmings and are anxiously offering these products to take advantage of customers by locking them in during low interest rate times.
Nobody has a crystal ball, and nobody is forcing anybody to do anything. However, it’s always good in any financial transaction to think how the other side is thinking.
MATCH GOALS WITH DURATION AND YIELD
A lot of things come to mind whenever I look for the best CD rates. The good thing is that you are able to spend the interest received freely, without penalty. My personal bogey is a 4% risk free rate of return. With the 10-year yield at only 3-3.2%, locking my money up in a 3% 10-year CD is mathematically not the right move. Unfortunately, every year that I don’t lock up my money at 3%, it’s 2.7% or so in lost interest opportunity since money market funds are yielding less than 0.3%.
Managing your cash is always very tricky because liquidity is still one of the most valuable assets to have. You might find a beautiful investment property to take down or a promising company start up you want to help bootstrap. That takes liquidity earning minimal returns now. The good thing is that these tricky things you face are all good things. Things could be worse and you could have no cash to play with!
Recommended Actions To Increase Your Wealth
Manage Your Finances In One Place: Get a handle on your finances by signing up with Personal Capital. They are a free online platform which aggregates all your financial accounts in one place so you can see where you can optimize. Before Personal Capital, I had to log into eight different systems to track 28 different accounts (brokerage, multiple banks, 401K, etc) to track my finances. Now, I can just log into Personal Capital to see how my stock accounts are doing and when my CDs are expiring. They’ve got the best Retirement Planning Calculator on the market too, which everybody should try it. They use your real linked data to assess your financial future.
Invest With A Low Cost Algorithmic Advisor: Wealthfront is an excellent algorithmic advisory choice for those who want the lowest fees and can’t be bothered with actively managing their money themselves once they’ve gone through the discovery process. In the long run, it is very hard to outperform any index, therefore, the key is to pay the lowest fees possible while being invested in the market. Wealthfront charges $0 in fees for the first $10,000 and only 0.25% for any money over $10,000. Their minimum is only $500 to get started. Invest your idle money cheaply, instead of letting it lose purchasing power due to inflation.
About the Author: Sam began investing his own money ever since he opened a Charles Schwab brokerage account online in 1995. Sam loved investing so much that he decided to make a career out of investing by spending the next 13 years after college working at Goldman Sachs and Credit Suisse Group. During this time, Sam received his MBA from UC Berkeley with a focus on finance and real estate. He also became Series 7 and Series 63 registered. In 2012, Sam was able to retire at the age of 34 largely due to his investments that now generate roughly $150,000 a year in passive income. He spends time playing tennis, hanging out with family, consulting for leading fintech companies, and writing online to help others achieve financial freedom.
Updated for 2016 and beyond.