When we first bought our $1,200 HDTV six years ago, we told ourselves never to go to the movies again until we watched enough DVDs to pay for the purchase. Every time we went to the movies, we'd have to pay on average $20 for tickets. A promise was made that only after we watched 75 DVD rentals ($1,500 bucks in movie tickets saved – $300 for Netflix fee), would we treat ourselves out to the theater. We reached our goal within two years, and in the four years afterwards we've only gone to three movies!
We realized that once we went through the initial 6 month waiting period for the latest movies to come out on DVD, all was fresh again. We're now programmed to watch movies with a 6 month lag, bringing us the same opening night excitement. The annoyance of someone sitting right in front of you in an empty theater and jabbering away is no more! Furthermore, a 52″ screen and six point surround sound system sure helps replicate the big screen experience!
THE DVD RENTAL METHOD OF CD INVESTING
Our programmed way of movie watching translates directly into how we employ our CD investment strategy. With the money we carve out for retirement savings (not emergency fund), we seek the highest yielding CD regardless of duration. Current 5-yr CDs are at 3.5-3.75% for example vs. 1.2% for short term savings and 1 year CDs. Every year we don't put money in a 5 year CD is 2.3%-2.55% in lost interest.
Some may argue inflation risk. Great we say, because rates certainly aren't going to ramp instantaneously, but if they do, we'll just dump our next year's cash into another 5-yr CD with a higher rate. Let's say for one year, we earn 4% in a 5-year CD vs. 1% in a short term savings account. With a positive 3% spread, our 2nd year short term savings account yield would have to ramp to 7% on average before the benefit of the first year is negated. At 7%, you should happily throw in another chunk of change. This is a problem of positives, not negatives.
There is a chance that you will need to tap your funds before the very initial 5 year period is done. The worst “penalty” that can happen for a 5-year CD is the forefeiture of 6 months worth of interest. Big deal! Chances are low you will need the money after you've built an emergency fund. By locking up your money, you are saving yourself from yourself.
CONCLUSION – LADDER UP AND BE PATIENT
Nobody knows how high inflation, and therefore rates will go. But, what we do know is that long term yields are generally always higher than short term yields. The yield at each duration reflect inflationary expectations. After waiting patiently for 5 years, your entire cash savings portfolio will return the highest yield possible. Meanwhile, every year, a good chunk of money comes due so you will always be liquid.
I've got six, five year CD's yielding 6.5%, 6%, 5%, 4.5%, 4.2%, and most recently 3.75%. The average yield is therefore about 5%, easily surpassing the current savings rate & current 5-yr CD rates of 3.5-3.75%. You are allowed to withdraw the interest portion of your CD as well, thereby lowering the need to withdraw the entire tranche and incur a penalty. By employing the DVD method of CD investing, your cash yield is optimized and you practice good long term savings habits along the way.
BONUS: Inflation Fighting Tips & How To Think About Inflation
1) Take on debt. If inflation is really coming, the solution is to take on as much fixed debt as your balance sheet can handle beforehand. Inflation literally inflates away your debt, given you will be paying back your fixed debt with inflated future dollars. In essence you are shorting treasuries, which will go down if inflation goes up, thereby making you money.
2) Buy hard assets. You may also think about buying as much hard assets as you can afford (property and commodities are good examples but not cars), because by definition your assets will inflate higher with inflation. Your cash, on the other hand will be eroded by inflation, so you must at the very least always seek maximum yield.
Related: Ranking The Best Passive Income Streams
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Post is updated as of 9/18/2017. Let the bull market continue! Don't forget to rebalance.
Regards,
Sam
I am amazed with this concept. I should probably try this one and share with my friends if it is really effective or what. Thanks for sharing this one.
It really is effective for that portion of your assets which are conservative and do not need. Just have to get through the preliminary phase of waiting without using the money. If you plan to live longer than 5 years in this example, it behooves you to employ this method to maximize your cash returns!
Sam –
With interest rates lower yet in 2010 (bankrate.com shows 3.05% being the top rate for 5-yr CDs), did you or will you buy another CD this year?
I started setting my finances straight by setting up an emergency cash fund. The goal is 10K, but I definitely don’t have that lying around. Contrary to your example, I’m not looking at returns yet, because they’re really nominal as far as my incremental investments are concerned. I’m building it 1K at a time, and once the pool reaches 10K, I’ll simply open a 10K CD, at the term that offers the highest return, and just let it sit there.
.-= The Personal Finance Blog´s last blog ..Starting a Laundry Business =-.
@admin
Just so I understand, that means you don’t let the interest compound? So every time you open a new CD it is with the exact same amount as invested in the last CD?
The reason I ask is because there is a big difference between netting and compounding and most people don’t understand this and it ends up costing them a lot of money. So I was interested to learn how you do things.
.-= Evolution Of Wealth´s last blog ..Financial Strength of Insurance Companies =-.
EOW -I do let the interest compound, but unfortunately, I can’t figure out a way not to pay taxes on the interest income that comes due every year. I pay the taxes, and the CD continues to grow every year. I do not take any of the interest income out, although I can with no penalty.
That’s the thing, if you have say $250,000 in a CD at 4%, you get $10,000/yr or $833.33/month in interest income the first year which continues to compound of course. So, there really shouldn’t be a NEED to withdraw more money from your CD, if this is your retirement allocated income.
How do you handle the taxes with this method? Do you net the taxes or rollover the full value of the CD each time?
.-= Evolution Of Wealth´s last blog ..Financial Strength of Insurance Companies =-.
@ EOW – You get the interest income form from the bank and you simply pay it as ordinary income as you go, or you can specifically ask the bank to reinvest into the CD, but that’s a special case.
@emptybob
Yep, makes sense. The thing is, as I write in this post, I constantly have new money every year as long as I work.
I called them, and it’s 7 yr CD for 3.85%… not the greatest, but not that bad I guess. I’ll think about it.
Ok, good long term objective. However, keep in mind that your “never to be touched money” will be under performing if interest rates rise to a level where it is beneficial to withdraw the funds and redeposit at the higher interest rate. There are a couple CD break even calculators that offer this analysis. That’s why the early withdrawal provision is so critical. I agree with you about seeking a high rate for a long term. But, it’s important to be able to reposition that money if interest rates rise. Make sense?
Sam: I read the disclosure and called USAA. The issue is not an early call of the CD by USAA, it’s a freezing of funds potentially during a rising (or falling) interest rate. This isn’t an issue of course during falling interest rates. But, if rates rise, the funds are locked into a potentially under performing position.
My understanding is that, according to the disclosure, they can deny an early withdrawal, thus freezing the funds for 7 years. The USAA rep I spoke with first said that this wasn’t the case, then I asked him to read their disclosure. He then confirmed my understanding that USAA could deny withdrawal of funds prior to maturity. He went on to say that USAA has never withheld funds for an early withdrawal. I told him, if that’s the case, them send me an amendment to the disclosure to that effect. I haven’t heard anything further.
Please check this out and see if I’ve come to the wrong conclusion.
Emptybob – Ah, got it, will do. I’m ok with not being able to withdraw the money, b/c all my CD money for investing is for retirement 8-10 years away. I have allocated this money never to be touched again. I will keep some other liquid short term money just in case. Will let you know if I find anything else out talking to them. Thnx, Sam
Sam: Wait! Read the 84 page disclosure. The provisions of the disclosure state that USAA “MAY” allow early withdrawal. This is completely unacceptable to me. If interest rates do rise – something that everyone expects – then the Put option is in jeopardy. While the interest rate is attractive, I’m not going to place money in an institution where I can remove it. That is likely the reason they are offering a 4.16% APY. Buyer beware and read the fine print.
Emptybob – That’s no problem for me or the customer frankly. I don’t mind earning 4.16% APY until they pull it because of an increase in rates! Why? B/c that means other institutions will also be offering higher rates as a result.
Shouldn’t we be considered if USAA can withdraw/remove the money if the rates DECREASE instead? Am i getting the understanding of USAA’s disclosure wrong?
I’m calling them anyway. I’ve been a member for 10 years!
Sam
This is one of the best articles on CD strategies I’ve seen. I use the authors exact approach, going long on the highest rates available. It is effectively a Put strategy, where the depositor holds a fixed option for terminating the deposit. Clearly, there are a number of risks, mostly with the term of the CD deposit. As an example USAA may not allow early withdrawal, even though they have an attractive 4.16% 7 yr CD. That’s unacceptable, as stated by others.
Also, all CD’s are not created equally. Brokered CD’s are substantially different than simple CD’s placed directly with a bank or Credit Union. Brokered CD’s are treated like a bond, where the market value of the CD changes as the market interest rate changes. So, if you sell a brokered CD early the CD may sell above or below its original cost depending on which way the market interest rates have moved. Also, and this is a bid deal, brokered CD’s are NOT listed by the bank as a deposit held in the individual depositor’s name. Brokered CD’s are held in bulk with a bank in the name of the broker, who in turn has an intermediary trust register the individual depositor’s name. This isn’t necessarily bad, but if there is any confusion about the CD registration with the depositor trust agent, then the CD may not be insured. It’s just another level of risk that isn’t found with a directly placed CD by an individual at a bank or credit union.
EmptyBob – Thanks for your thoughts, and stopping by!
Dang, 4.16%, 7-yr CD from USAA? I’m a member! I’m gonna call them tomorrow and check them out! That’s a no brainer in my opinion, seriously! Thanks for the tip.
Best, Sam
@Dan Smith
Yes, important to read the fine print. Looking at the Ally website, they do not mention anything about unable to redeem a CD “at their discretion”. The only exception they list for early withdrawals penalties, is that they will wave the penalty if you should happen to die or be judged legally incompetent.
Just to be sure, I called them up, and they confirmed that for the 3,6, 9, 12 month CDs — they have a 90day (3 month) interest penalty. The 18month and longer CDs carry a 6-month penalty. At no point will they EVER DENY you from getting at your money.
Perhaps you should not be doing business with shady banks…
Do not, not, not just assume that “The worst “penalty” that can happen for a 5-year CD is the forefeiture of 6 months worth of interest.” The terms and conditions of CDs vary. You must read the fine print. It is not always the case that you have the right to redeem the CD before maturity if you are willing to pay the penalty. Sometimes the fine print will say that redemption before maturity is at the bank’s discretion.
No, I haven’t had bank a bank refused me early redemption. Yes, the state banking division has told me that it CAN happen and is HAS happened.
If interest rates go up, there are going to be a lot of people wanting to redeem CDs before maturity. The banks aren’t stupid and are willing to play hardball. If your strategy calls for redeeming a CD before maturity, be darned sure that you’ve read the fine print and asked the probing questions and that you KNOW you have the right to do this.
Hi Dan! I agree, READ THE FINE PRINT folks before signing any contract. Ask the banker straight up questions before doing anything. That goes for signing a mortgage loan, buying a car, anything.
My strategy does not include redemption. Early CD redemption is only of the last resort. The money I have carved for the DVD CD strategy is entirely for retirement purposes, and seperate from my emergency fund, etc.
If rates go up, awesome! I’ll just dump more into the higher yielding instrument for 5 years. The spread of 4% – 1.25% is nice and steep. CD yields would have to ramp to 6.75%, and stay there for a year before one starts losing out. I just don’t see this happening.
Thanks for stopping by and sharing your thoughts! FS
@Ken
I second admin, the Credit Unions around my area are not competitive, unless you are able to put $100k into one. You can use:
https://www.bankrate.com/cd.aspx
to comparison shop. Ally bank usually has good rates, and their worst penalty is 6-month for CDs with 18+ month terms. CDs under 18 month have a 3 month interest penalty.
@Ken
Sounds good! I’ve never seen a 30 month interest penalty on early withdrawal for a 5-yr, but that’s good to know. Best for all of us to double check the contract and go with our eyes wide open!
I’ve been disappointed with Credit Unions around the Bay Area. I’ve check out 3 of them, and all are uncompetitive. But, I’ll keep a look out.
Thanks for stopping by Ken, and hope to hear more from you in the future.
Best, FS
Note, there are some 5-year CDs that have a more severe early withdrawal penalty than 6 months of interest. I’ve seen some as bad as 30 months of interest. You can still get a 4% CD, however, most are 7-year terms with a 1-year early withdrawal penalty.
Also, don’t forget credit unions. They often offer higher CD rates than banks, and the vast majority are federally insured.
In addition to the risk of inflation and rates going up, there’s also the risk of rates remaining low. Long-term CDs are a good way to hedge against this risk.
@admin
Excellent stuff ;)
I’ve got about 8 years till debt freedom.
@BG
BTW BG, my co-writer, Shogun has no debt, and several million in cash yielding over $120,000/yr in interest income and employs this strategy as well. His house is fully paid for. Me, on the other hand, I’m on a 10 year journey til freedom. :)
Hey Admin,
any pointers as to where you have:
“I’ve got six, five year CD’s yielding 6.5%, 6%, 5%, 4.5%, 4.2%, and most recently 3.75%”
??
Just to know where I can get that kind of rates…for 5yrs. term….
Player – You can get a 5 yr CD at Citigroup for 3.5-3.75% right now. It was 4% last year. Look for banks looking at raising long term money, and they will throw consumers a bone. The other rates were locked in within the past 4, 3, 2, 1 years ago at various banks including: First Republic Bank, Bank of America, and Citibank. Good luck!
@admin
I didn’t realize that you were already carrying debt — not to pry too much, but if your CDs are earning 5% (on average), what is you average debt interest rate?
FYI: very good point about cashflow — you can be a millionaire (on paper), but if you don’t have the monthly cashflow to make payments, you might end up in bankruptcy.
BG – Yes, I still have a mortgage on my home and my rental. 4.625% for primary, and 5.25% for rental. The rental will likely be paid off in 8 yrs or less. The home, I will probably sell in 10 yrs.
One can’t expect to have their blended average CD return equal or cheaper than their interest costs. FS
@Charlie
Sounds good Charlie! I hope you get a nice big fat juicy bonus, b/c I tell ya, the economy is surely back! Good luck!
I like this concept. I’ve been flip flopping on whether I want to put some money in a 5 yr CD. If I get a bonus this year (I sure hope so!) I think I will definitely put a good portion of it in a 5 yr. It’ll prevent me from spending it on something stupid and even if it’s 3.75% it sure beats my measly 1% money market.
@BG
Sounds good BG. I hear what you are saying. What you are bringing in is the age old debate of whether to pay down higher interest debt or not. That is another topic worth dedicating a post to!
Essentially, it’s just an accounting and security question. I COULD pay off a lot of debt, but I like being liquid, and I know the debt will be paid off eventually due to amortization, and my cash flow is fine. Everybody has their own strategy and threshold to paying off debt. In 10 years, i know I will be debt free, but for now I’m happy to support debt because I have the cashflow.
Financial Samurai
@admin
I agree that longer-term CDs almost always have higher yields. The point I’m making is that every year you should look at all of your fixed-rate (CD) holdings, and consider selling any to buy something else that can generate a higher fixed-rate return — this would be my strategy in both a rising or falling CD rate market. In a falling market, it would work exactly as you have been doing (never selling the old CDs).
To show how this would work in a hypothetical rising market:
4.2%, 4.5%, 5%, 6%, 6.5%
you are still averaging 5%, yet “today’s” going rate is 6.5% — you can immediately capture the extra 1.5% buy liquidating the older CDs early. Best to crunch the numbers to see where the break-even points are w/ respect to the penalties.
As for taking on new fixed-rate debt in expectation of higher inflation: It depends on what you buy with the loan money. If you take out a mortgage today @ 5% from your already paid-for house, and put all of it into 5-yr CDs earning 3.75%, you are immediately -1.25%. Every year that goes by that you hold the loan, and the CD yields are not higher than the loan rate, the harder it is going to be to recover those ‘real’ losses. Hence, why I call this strategy “risky”: you need to be able to predict the future accurately to come out ahead, because you immediately start out negative.
I really like the idea of always looking for the best CD to invest new money (regardless of term), and that is why it would be better to pay down any debt first (with new money) if the best CD yields are not significantly higher than the interest on outstanding debt. I say “significantly higher” because there is inherent risk in carrying debt.
@BG
It’s true, this has been a good strategy in a declining interest rate environment, but crunching the math, it is also a good strategy in a rising interest rate environment. Why? Because the yield curve is always generally sloping upwards, hence the yield curve may shift up, but on a relative basis, the longer duration CD always yields higher than the shorter term duration CD.
If you load up on fixed rate debt now at a lower level, that is exactly the right call in a rising interest rate environment due to inflation. Clearly, there is generally a positive spread on lending rates and time deposit rates, b/c that’s what banks do by definition, borrow low, lend high.
Of course, if you are an absolute interest rate genius and know that rates will rise to X % by X time, then you can strategize accordingly and do the math to determine when it is to lock. However, if you do know this, then you should run a mega billion interest rate hedge fund instead :)
This strategy seems to be pretty good (in hindsight) in a market with falling CD-rates. But is it as good in a market of rising CD rates? Consider this hypothetical: current 5-yr rate is 3.75%, next year’s 5-yr CD rate is 8%. Would you really hold on to 4 more years of the original 5-yr CD @ 3.75% — no, you’d likely bust it, eat the penalty, and reinvest it at the new 8%.
Also, the risky strategy about loading up on fixed-rate debt seems to be completely opposite of the original CD-ladder strategy of getting the best rate for today’s dollars. If you load up on new debt, which _will_ have a higher interest rate than today’s CDs, then the “new” best place for your money (chasing highest rate) would be to pay down the debt and stop buying CDs…
@admin
Perfectly done, in my mind. You took the highs with the lows and still come out averaging 5%, which is better than any savings account right now. Good job!
@Lee
Sounds good Lee. I just added this bit “I’ve got six, five year CD’s yielding 6.5%, 6%, 5%, 4.5%, 4.2%, and most recently 3.75%. The average yield is therefore about 5%, easily surpassing the current savings rate & current 5-yr CD rates of 3.5-3.75%. You are allowed to withdraw the interest portion of your CD as well, thereby lowering the need to withdraw the entire tranche and incur a penalty.”
It’s a no brainer mate. It’s a problem of positives…. i.e. making more than you could.
The closer I get to being debt free, the more I seem to pay attention to these kinds of articles. I have a bookmark folder of “things to read when debt free”, and this has been added to it. Most of them go in completely unread (a nice batch of things to read when the time comes), but I felt drawn to read this one as I don’t go to the theatre either and I get LoveFilm (UK Netflix) also!
This seems to be a similar theory – to my untrained mind – of pound/dollar cost averaging. If you do it little and often, you’ll ride out the bumps?