Taking the "What If" Out of CD Rate Decisions
June 12, 2009
"What if" can be a valuable question to ask before making decisions, but it can also become paralyzing. There will always be "what ifs" that discourage you from making certain decisions, but just because something could happen does not mean it is likely to happen. Determining that probability is one of the keys to making informed decisions. Think of it as squeezing down the "what ifs."
Take CD rates for example. The most remarkable characteristic of CD rates lately has been the huge spread between long-term and short-term CDs. The reward for moving out from a 1-month to a 6-month CD has narrowed a little lately, to 90 basis points, but this is still much higher than the historical average. So, assuming you had the liquidity to choose freely between a 1-month and a 6-month CD, what would prevent you from taking the sharply higher 6-month CD rate?
Just a "what if."
What if CD Rates Move Higher?
If CD rates moved higher, you'd have to wait longer to roll over at higher rates if you locked into a 6-month CD rate now. However, how high would CD rates have to rise to overcome the 90 basis point (.9%) advantage of 6-month CD rates currently?
Well, assuming 1-month CD rates rose at a steady pace over the next 6 months, they'd have to rise about 180 basis points (1.8%) to both catch up with 6-month CD rates and make up for the lost interest in the first few months. 1-month CD rates have only risen that far that fast in 7.9% of all 6-month periods in the past. Historically, then, that's the probability that you'd lose out by taking advantage of a 90 basis point higher 6-month CD rate.
A 7.9% probability doesn't eliminate that "what if," but it does squeeze it down pretty well. And, if you're wrong, at the end of 6 months you'd get the comfort of getting your next CD at a sharply higher interest rate anyway.
