CD Rates and Early Redemptions

The advantages of bank CDs and U.S. Treasury securities are they have almost no risk to principal.  An investor in Treasury securities can experience a loss if they sell the security at below its face value before it matures; otherwise the resources of the U.S.government back the principal and interest payments.  Similarly, an investor in a bank CD can incur a loss if they sell the CD prior to maturity and incur an early redemption charge; otherwise the principal is secured by the full faith of the U.S. government via FDIC insurance.

The value of the CD for the bank and one of the primary reasons for the high rates on CDs is they are meant to be a bought and held to maturity.  If CD account holder needs the money prior to when the CD is scheduled to mature, a penalty for early withdrawal will be assessed. That penalty is typically the loss of three to six months worth of interest income but the actual amount is determined by the bank with the exception of the minimum levels set by federal regulation.

Early redemptions are real, yet manageable disadvantage found in long-term CD rates.  Managing the risk of early redemption is as simple as managing the investment time horizon involved in holding these funds.   Understanding an investments time horizon is important for all investment vehicles.  A retiree would certainly be ill advised to hold 100% of their portfolio in high growth tech stocks.  The same is true with the time horizon of CD accounts.  No one should chase the high yield of five-year CD rates without knowing how likely is it that they will need to redeem the investment prior to the five-year maturity.

The high rates of bank CDs combined with their safety and soundness have increased the demand for these products throughout the year.  With the variety of high rate CDs available and the continued slump in a most other assets classes, their value has risen as a very important investment tool.  The rates on CDs easily surpass that of Treasury securities and money market accounts.   The high rates paid on bank CDs combined with the inherent lower risk than comparable assets should help to maintain the flow of investor dollars into these accounts. 

An astute investor needs to pay attention to the rates, the risk of early withdrawal and the time horizon for the funds being allocated to the CD.  Don’t just focus on the interest rate and term of a CD and ignore the potential need for early withdrawal.  By surveying the lists of CD rates on the enclosed tables you will find a variety of maturities offering high rates.  Chasing the five-year rate may not be the best decision when the two-year CD rate pays an equal amount.

Evaluate the rates across maturities and pay attention to the time horizon for the funds invested to avoid the ugly fate of early redemption fees.

This entry was posted on Friday, October 31st, 2008 at 9:22 pm and is filed under Money Rates. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.