2

As of August in 2018, everything I'm reading is projecting rising interest rates for a while.

Assuming that this is what happens, is it better to deposit money into a shorter-term CD (at a lower interest rate now) with the expectation of redepositing into another CD later (at a future higher interest rate) or to deposit into a longer-term CD (at a higher interest rate now)?

I'm curious if there's any existing advice on something like this since I could otherwise fairly easily calculate the future interest rate required to make it worthwhile.

As an example, say a 4-year CD is currently offering 2.65% APY and a 2-year CD is currently offering a 2.5% APY. Over 4 years, the former would gain ~11%. Over 2 years, the latter would gain ~5%. Redepositing the 2-year CD into another 2-year CD would require a 2.79% APY. In other words, I'd have to expect interest rates to rise by ~11.6%, or ~0.2 points, over two years for it to make sense.

3

everything I'm reading is projecting rising interest rates for a while.

Then that expectation should be built into CD rates. In other words, the market's expectation of the change in interest rate in 2 years should make it an indifferent decision to buy a 2-year CD now and another 2-year CD in 2 years versus buying a 4-year CD now.

So the only difference is how rates actually rise relative to those expectations. If they rise more than expected, then you'd be better off buying short-term investments and reinvesting when they mature. If they rise less than expected (but still rise), then you'd be better off locking in the rate for a longer time.

If they rise exactly as expected, then it will make no difference.

Your math on the expected future rate is pretty close. The formula would be

(1+r(2,2))^2 = (1+r(0,4))^4 / (1+r(0,2))^2

Meaning the square of the expected 2-year rate 2 years from now is the current 4-year rate to the fourth power divided by the current two-year rate squared.

Evaluating that equation yields an expected 2-year rate in 2 years of 2.80%. If you think the rate will be higher than that in 2-years, then buy the 2-year CD. If you think it will be lower, then buy the 4-year CD.

  • "Then that expectation should be built into CD rates." But are they? These are consumer products, not bonds. – RonJohn Aug 14 '18 at 21:29
  • @RonJohn That's a good point. They might not represent expectations as purely as bonds, but I'd still expect that banks would set the rates based on their market rates. – D Stanley Aug 14 '18 at 21:53
  • 1
    I see three elements in determining the current market rate for a given CD: #1 The current Fed rate. #2 What other banks are offering. #3 Customer expectations of where rates will be in X months (which is just what you said). IMO, at this time, long-term rates aren't sufficiently high enough to get me to lock into anything longer than 12 months. – RonJohn Aug 14 '18 at 22:01
  • I don't know a thing about the formulas for CD expectations. From observation, CDs of shorter duration are more responsive to interest rate increases than those for a longer term. The average U.S. CD for 1 year CDs has doubled in less than two years. The average for two year CDs has doubled in three years. The 4 year CD is up only 50% in that time period. It's not a linear relationship. In slow rising rate environment, tt might not make much difference in terms of the choice of two consecutive 2-years CDs versus a 4 year but for the guy laddered with less frequent maturities, it might. – Bob Baerker Aug 14 '18 at 23:13
  • 1
    In general, the formula would be R(0,1) * R(1,1) * R(2,1) * R(3,1) = R(0,4)^4, where R(i,j) is 1 plus the expected j-year interest rate i years from now. So you have one equation with three unknowns, unless you can define two of the unknowns in relation to the other. Then the math gets even hairier. – D Stanley Aug 16 '18 at 18:48

Your Answer

By clicking "Post Your Answer", you acknowledge that you have read our updated terms of service, privacy policy and cookie policy, and that your continued use of the website is subject to these policies.

Not the answer you're looking for? Browse other questions tagged or ask your own question.