July 30, 2009
The potential costs of going long
People who invest in CDs - that is, certificates of deposit - are facing a tough decision. If you're willing to invest your money for five years, you can double the interest rate earned compared to investing for six months. So is this a no-brainer, the higher rate for the longer time is the way to go?
Dr. Mike Walden, North Carolina Cooperative Extension economist in the College of Agriculture and Life Sciences at N.C. State University, responds:
"Well, I don't think it's a no-brainer, but it's certainly a head-scratcher. Obviously, you do want to earn the highest interest rate you can on your money. What you have to worry about with CDs and tying up your money is whether that interest rate that looks good today is going to look good in a couple of years. For example, what if you did invest your money right now in a CD that's, say, paying you 2 ½ or 3 percent but you have to commit your money for five years. Well, what if in a couple of years, we have runaway inflation and new CDs are offering people 6 percent or 7 percent. Well, then obviously you would have made a mistake, because the rate that you're getting, that you're locking into now is low compared to what you could get. Now the problem is that yes, you could say, ok, I'm going to sell my existing CD, but you're going to have to pay a penalty for that because CDs do want you to lock up the money. And if you don't lock up the money, they're going to say, hey, you broke a contract, we're going to assess a cost. So this is a head-scratcher, and those people who think we're going to have significantly higher interest rates in the future probably want to go short. They want to go with six months or one month or one year CD. Those people who say, no, all this stuff about higher inflation, high interest rates down the road, that's all just hype. They don't see rates going higher. Well, then they would want to look at, say, a five year CD. People who say, well, I don't know, probably the best decision is to go in the middle, go with something like a two- or three-year CD."
Posted by Dave at July 30, 2009 08:00 AM