When Rates Rise or Fall: Adjusting Your Cash

Which of these are you?

• Rates have fallen and you hold a CD bought earlier. Keep it. A CD that pays more than today's sheet is an asset. Do nothing until it matures.
• Rates have risen and you hold an older CD. Test the break with the break-even model in this chapter. Break only if the net advantage is positive after the penalty.
• A rung is maturing. Renew it for the term your dates require. Do not stretch the term because rates look high or short it because they look low.
• You are holding cash and waiting for a better moment. Compute what waiting costs and what rate would repay it. Then decide whether that rate is realistic for your money.

The guardrail: no market timing

This chapter uses no rate forecasts, and none of its rules depend on one. Every recommendation is conditional: if rates are X when a rung matures, do Y, and the cost of Y is computed. That is deliberate, for three reasons.

First, nobody reliably calls the turn. The Federal Reserve holds eight regularly scheduled meetings a year, and its calendar page states it also holds other meetings as needed. A decision can come on a date you did not plan around, and market rates often move ahead of an expected decision.

Second, market yields already carry expectations. Federal Reserve staff describe the forward rate at a given maturity as the market's expected short rate at that horizon plus a term premium, and they note that a curve-based predictor may work because it impounds expectations that market participants have already formed. If you buy a CD after the market has repriced, the news is already in the rate.

Third, timing costs something you can compute. Cash waiting for a better rate earns whatever the waiting account pays, and the difference is a certain loss set against an uncertain gain. The worked example below prices that trade.

The alternative to timing is a rule set written in advance from your dates. Rules written in advance keep a headline from making the decision, and they work whichever way rates go. Nothing here is advice on whether rates will rise or fall, and no rate stated in this chapter is a current rate. All rates are hypothetical.

What waiting costs: a worked example

Waiting to buy a CD is a bet that you will find a higher rate later than the rate you can lock now. The break-even rate tells you how much higher the later rate has to be.

Setup (hypothetical). You have $50,000. Option A: lock a 12-month CD at 4.00% APY today. Option B: hold the money in savings at 3.50% APY for 3 months, then buy a 9-month CD, so both options end 12 months from today. Annual compounding, no taxes.

Formulas.

• Option A value at month 12: 50,000 x (1 + 0.04)
• Option B value after 3 months: 50,000 x (1.035)^(3/12)
• Break-even 9-month APY x: solve 50,000 x 1.035^(3/12) x (1 + x)^(9/12) = 50,000 x 1.04, so x = ((1.04 / 1.035^(3/12))^(12/9)) - 1

Steps.

1. Option A at month 12: 50,000 x 1.04 = $52,000.00.
2. Option B after 3 months in savings: 50,000 x 1.035^0.25 = $50,431.87.
3. Break-even rate: (1.04 / 1.035^0.25)^(1.3333) - 1 = 4.17%.
4. If the 9-month CD then pays 4.00% (no change): 50,431.87 x 1.04^0.75 = $51,937.39, which is $62.61 short of Option A.

So waiting costs about $62.61 if rates do not move, and it only pays off if a 9-month CD pays more than 4.17%. That is a rise of 0.17 points from the 4.00% you could lock today. The size of the rise you need is the useful number, because you can ask whether it is a realistic bar for your money without forecasting the direction. The mirror image also holds: if you lock today and rates fall, the locked CD wins by more than the gap above, because a later 9-month CD would pay less than 4.00%.

The example is small because the horizon is short. The principle holds at any size: the cost of waiting is the interest you forgo in the meantime, and the break-even rate is the price of the wait.

Rates fall: what changes and what does not

When rates fall, three things are true. A CD you already hold that pays more than the new sheet is worth keeping. A rung that matures renews at a lower rate. And cash sitting in a variable-rate account earns less. The rule set follows from those facts.

1. Keep older CDs to maturity. Breaking a CD that pays above today's rates gives up the good rate and pays a penalty. The lost rate and the penalty both work against the break.
2. Renew maturing money under the renewal rule. Extend only money you will not need for the term, and only if the longer term pays at least as much as the shorter ones. A longer term locks the rate you have, but only for money whose dates are outside the term. Tier 3 dated goals inside 181 to 720 days stay in terms that end on those dates.
3. Keep the Tier 2 reserve liquid. The reserve is for emergencies, not for chasing a rate. Its job does not change when rates fall.
4. Be careful with callable CDs. A callable CD lets the issuer redeem it early, which is a feature to understand before you buy. Chapter 10 covers callable, step-up and no-penalty structures.

The cost of keeping access when rates fall is the gap between a ladder and a locked CD. The next section prices it.

Ladder against long CD when rates move

This example uses the tested comparison function from Chapter 12 on a shorter horizon. All rates are hypothetical.

Setup (hypothetical). $100,000 over 3 years. Ladder: three equal rungs at 4.00%, 4.25% and 4.50% APY for 1, 2 and 3 years. One long CD: $100,000 at 4.50% for 3 years. Reinvestment APY before any shift: 4.00%.

Read this as insurance pricing, not a forecast. If reinvestment rates fall 2 points, the ladder trails by $3,059.13. If they rise 2 points, the ladder leads by $1,274.21. At no change, the ladder trails by $906.32 because its early rungs earn less than the long CD. The ladder's cost is the price of having money back each year. You decide whether that access is worth $906.32 on $100,000 over three years, not which way rates will go.

Rates rise: when breaking a CD can pay

When rates rise, a CD you hold looks worse against a new one. Whether to break it is an arithmetic question with a penalty in it. The model of record reinvests the balance after the penalty at the new APY for the remaining term and compares it with keeping the CD. Annual compounding, taxes excluded.

In this hypothetical the break nets $3,310.34, and it breaks even at a 3.138% replacement APY. That is a large gap between the old and new rates, 2.25 points, and the break still needs a replacement above 3.138%, not just above 2.50%, because the penalty comes out of the money you reinvest. A rise of a fraction of a point on a CD with a long time left rarely clears the penalty. The penalty mechanics are in Chapter 3.

Before breaking anything, check whether a no-penalty CD or a shorter rung would have avoided the problem in the first place. When rates rise, the structures that renew soonest gain the most. When you build new positions in a rising environment, stagger maturities so a rung renews at each step, or hold Tier 2 reserve money in savings or Treasury bills that reprice quickly.

For brokered CDs, rising rates carry a price risk that a bank-direct CD does not have. FINRA's notice says that when interest rates rise, the market value of a long-term CD declines, and that there is no insurance coverage for principal losses if you sell in the secondary market before maturity. If you might sell, count that.

The regime table

Peaks, seasons and the calendar

People ask when CD rates peak and whether a certain month is best to open one. A peak is visible only after rates have turned, so any rule that says "buy at the peak" cannot be applied in real time. The Federal Reserve's published calendar tells you when a decision can happen, not what it will be.

New-CD rates change when banks reprice, so choose a structure that works whichever way they move.

Write the rules before you need them

A rule set is a short list you write once and apply at each maturity. A usable version has four lines.

1. The date rule: every block of money has a date, and no CD term ends after it.
2. The renewal rule: a maturing rung renews for the longest term that still ends by its date, provided that term pays at least as much as the shorter ones (if the curve is inverted, run the break-even in Chapter 11 first) and you do not need the cash before the next rung matures.
3. The break rule: an existing CD is broken only when the break-even model shows a positive net advantage, with the actual penalty from your account agreement.
4. The wait rule: money waits only if you have computed the break-even rate and judge it realistic, and a wait has an end date.

Chapter 19 turns these into your one-page plan. Chapter 8 covers what to do on the day a CD matures.

Use the CD early withdrawal calculator on any CD you are thinking of breaking, and the ladder scenario calculator above on any structure you are choosing. If the numbers do not clear the break-even, the rule set says to hold, and you can hold without needing to be right about the next rate move.