A few days ago a kindly Pilgrim reader (Paul) asked me about breaking a CD’s term, giving up some interest and investing his money elsewhere. He wanted to know if it was a smart move. Sometimes it is….but not always. Here’s an excerpt from the email:
I’m wondering if I should break my CD and pay the penalty to jump out. Although the interest is 2% and that’s great- I’d think I’d be better off dumping the $ into Asset Manager 85/15 fund. It is making 7.9 for this last 1/2 yr. The other idea I am considering is precious metals or short term municipal bonds. What do you think I should do?
I was so happy to get this email and I’ll answer his questions. But more important, I want to take another look at how investments work. I think that might even be more helpful to Paul. Let’s dive in.
“Should I break my CD and pay the penalty?”
Paul understands that when you deposit money in a CD you tie up those funds. That could be for 30 days or 36 months. And if you want your money back before that time is up, you’ll get slapped with a penalty. The size of the penalty varies with the length of the CD. The longer you tie the money up, the greater the penalty.
With a rate of 2% Paul probably signed up for at least 2 years. For our purposes, let’s say the penalty is 6 months interest. In this case, that means he’ll forfeit 1% which isn’t that bad. But let’s go on.
“I’d be better off dumping the $ into my Asset Manager fund. It is making 7.9%”
Paul asks about reallocating his money from the CD to an equity mutual fund, a precious metal fund or a short-term muni bond fund. These are good questions of course. But the answers aren’t simple. That’s because each of these investments have very different risk profiles. I’m not 100% convinced that Paul really understands that.
He’s comparing the 2% CD with the mutual fund and other alternatives based on return alone. No Bueno. What about risk? Sure the fund earned 7.9% in the last six months. But that’s got nothing to do with what the fund might do going forward. It could lose 7.9% (or more) over the next six months for all anyone knows.
Paul is doing what lots of people do – and it’s costly. I could be wrong but based on what he wrote, he seems to think that a fund “earns” a set return – it doesn’t. The CD pays a low rate specifically because it gives you something the fund can never give – certainty. Paul needs to really understand what mutual fund returns really mean.
Paul asks about precious metal funds and municipal bond funds too. These are very different investments compared to the CD as well. Precious metal funds are speculative and very aggressive investments. Bond funds on the other hand are typically much more conservative but still more risky than CDs. It feels like Paul is comparing investments based purely on what the returns might be. Aye Carumba!
How To Avoid Falling Into This Trap
Before you invest a dime, get clear on your investment time-frame and ultimate objectives – and keep in mind that other considerations might be far more important than return on investment. Think about when you’ll need the money back and how much risk you are willing to take during the term too.
If you own a CD and you don’t think you’ll need the money for 5 years or more it might be smart to break the time deposit and invest elsewhere. (If that is the case ask yourself why you bought the CD in the first place)
If, on the other hand it’s likely that you’ll need the money within two or three year, you might stick with the CDs. The return will disappoint you but you’ll have safety and liquidity. Most important, you know the money will be there when you need it.
In short, investing is about return – but it’s not only about return. When liquidity and safety are very important, a CD might be the very best way to go.
Have you ever broken a CD? Why? Was it worth it?