It’s Better to Invest in a 5-Year CD For 3 Years Than Buy a 3-Year CD

It’s Better to Invest in a 5-Year CD For 3 Years Than Buy a 3-Year CD

bank cd ratesThinking of putting some money into a safe, short-term investment vehicle? Especially if you’re looking into making a big purchase such as a house or car soon.

CDs are a good way to protect your money while keeping it growing ever so slightly. If you’re looking into buying 1 or 2-year CDs because you’re buying a house soon, you may want to rethink that and consider a longer term CD.

Ally bank offers a 3-Year High Yield CD and a 5-Year High Yield CD, for 2.60% and 3.10% respectively, compounded daily. Source: http://www.ally.com/bank/cd-rates/#all-cd-rates

What if you bought a 5-year CD and cashed out after 3 years?

Let’s pretend you want to put away $5,000 and assuming interest is compounded daily for 365 days a year, instead of 250 business days per year.

It’s Better To Buy A 5-Year CD for 3 Years Instead of a 3-Year CD

3-Year High Yield CD:

If we apply the Future Value formula

FV = PV(1+r)^t

  • Setting Present Value (PV) = $5,000 deposit
  • Rate of Interest per day (r) = 2.60% / 365
  • Time (t) = 3 years x 365 days per year

Future Value (FV) after 3 years = $5,405.60

Now let’s do the same for the 5-Year High Yield CD, but we’re going to cash out after 3 years

5-Year High Yield CD

FV = PV(1+r)^t

Future Value (FV) after 3 years = $5,417.83

As you can see from the above calculations, you’re making an extra $12.23┬áby choosing the 5-year CD and cashing out after 3 years.

Of course this isn’t true for all CDs. Additionally, it also depends on how much your deposit is. Different banks will have different tier of interest rates. These are affected by how much you want to deposit into a CD.

What Happens If We Deposit $10,000 Instead of $5,000?

If we take the above example, and instead deposit $10,000, we get bumped up to the 2.70% interest rate for the 3-Year CD.

In that case, the 3-Year CD becomes a better choice than the 5-Year CD based on the following values:

3-Year High Yield CD:

  • Setting Present Value (PV) = $10,000 deposit
  • Rate of Interest per day (r) = 2.70% / 365
  • Time (t) = 3 years x 365 days per year

Future Value (FV) after 3 years = $10,843.68

Now let’s do the same for the 5-Year High Yield CD, but we’re going to cash out after 3 years

5-Year High Yield CD

  • Setting Present Value (PV) = $10,000 deposit
  • Rate of Interest per day (r) = 3.10% / 365
  • Time (t) = (3 years x 365 days per year) – 150 days penalty for cashing out early

Future Value (FV) after 3 years = $10,835.65

In this case, it becomes more economical to buy the 3-Year instead of buying the 5-Year CD and cashing out after 3 years. The difference is $8.02. Of course the optimal thing to do would be to buy two 5-Year CDs for $5,000 each and cash it out after 3 years. This will net you $24.46 in positive differences.

For you convenience, I’ve created an Excel spreadsheet to compare rates of CDs. Fill in the required information in the highlighted cells on the left hand side, and the spreadsheet will compute the future values for you in the blue side. Excel Spreadsheet

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2 thoughts on “It’s Better to Invest in a 5-Year CD For 3 Years Than Buy a 3-Year CD”

  1. I love Ally Bank too for their great rates. I hadn’t considered that there would be a benefit to cashing out a CD early. Thanks for pointing this out!

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