Using an Implied Interest Rate to Compare 5-Year and 6-Month CD Rates

August 11, 2009

| MoneyRates.com Senior Financial Analyst, CFA

The Long and the Short of It: CD Rates

If you are looking at certificates of deposit, one of the most fundamental choices you face is the trade-off between liquidity and interest rates. Short-term CDs offer more liquidity, but longer-term contracts will offer the best CD rates. How do you evaluate this trade-off?

The question is especially intriguing right now, with 5-year CD rates running at roughly double the level of 6-month CD rates. That's a compelling difference--but how do you know if it's compelling enough to lock in your money over the extra four and a half years? Answering that question starts with thinking about what you expect to happen over the course of that four and a half years.

The Implied Interest Rate

One way to look at that four-and-a-half-year period is mathematically. You can compute what interest rate is implied over that period by looking at what CD rate you'd have to earn over the last four and a half years if you invested at current 6-month CD rates for the first half year, and still wanted to earn the same average rate over the full five years.

As of late July, 6-month CD rates were averaging 1.41%, while 5-year rates were averaging 2.75%. One way to look at what this implies about that last four and a half years is to figure out what interest rate you'd have to earn over that time to average 2.75% over the full five years, if you started out by earning the 6-month rate for the first half year.

To do this, you compound 2.75% over five years, and then back out 6-months worth of interest at the annual rate of 1.41%. This tells you that you'd need to earn a total of 13.73% over the last four and a half years to average 2.75%. 13.73% works out to an annualized rate of 2.90% over the final four and a half years.

Other Assumptions

This implied interest rate over the final four and a half years is important, because you can put it in the perspective of what you expect to happen over that period.

For example, looking at current interest rates, it would take a big jump in rate for them to reach 2.90% in the next six months. The longer it took rates to rise, the higher they would have to go in order for you to average 2.75%. By this logic, locking in 2.75% would seem a good deal.

On the other hand, if you believe that once the economy recovers inflation will return to its normal level, then you'd have to think twice about the 5-year CD. A normal inflation level is around 3% to 4%, and if this happens soon, it would make that 2.75% seem pretty paltry.

In short, calculating the interest rate implied by the difference between short and long-term CD rates is a key first step in evaluating whether the difference is worth being locked in for a longer time. It gives you a benchmark against which you can compare other assumptions about what you expect to happen over that later period.

 

Source:

Mark Davis • Looking for better CD rates? Shop around. • Jul 17, 2009 • http://www.kansascity.comhttp://www.kansascity.com/business/story/1331620.html

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