Brokered CD Interest Compounding

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sport
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Brokered CD Interest Compounding

Post by sport » Thu Apr 19, 2018 10:39 am

Vanguard has 2 year CDs at 2.65% that pay interest semiannually and 2.60% that pay interest monthly. Assuming the interest payments go into the sweep account that pays 1.55%, which CD yields the most considering the compounding of the interest in the sweep account? Similarly, 3 year CDs at 2.85% pay interest semiannually, and 2.80% pay interest monthly. Which has the higher yield?

sport
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Re: Brokered CD Interest Compounding

Post by sport » Thu Apr 19, 2018 8:03 pm

I thought that this would be an easy question for our CD experts. It certainly would be worthwhile to know the answer. Thanks.

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welderwannabe
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Re: Brokered CD Interest Compounding

Post by welderwannabe » Thu Apr 19, 2018 8:09 pm

sport wrote:
Thu Apr 19, 2018 10:39 am
Vanguard has 2 year CDs at 2.65% that pay interest semiannually and 2.60% that pay interest monthly. Assuming the interest payments go into the sweep account that pays 1.55%, which CD yields the most considering the compounding of the interest in the sweep account? Similarly, 3 year CDs at 2.85% pay interest semiannually, and 2.80% pay interest monthly. Which has the higher yield?
When comparing, are you looking at yields or what the distributions are. Yields assume that the coupons can be invested at the same rate as the bond. In other words, a bond with a 3% yield that pays monthly assumes that the coupons can invested in a similar security earning 3%. This is often not the case and is a component of 'reinvestment risk'. This is one reason some people like zero coupon bonds.

So, if those are your two options go with the 2.65% 2 year CD.
I am not an investment professional, but I did stay at a Holiday Inn Express last night.

sport
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Re: Brokered CD Interest Compounding

Post by sport » Thu Apr 19, 2018 8:19 pm

welderwannabe wrote:
Thu Apr 19, 2018 8:09 pm
sport wrote:
Thu Apr 19, 2018 10:39 am
Vanguard has 2 year CDs at 2.65% that pay interest semiannually and 2.60% that pay interest monthly. Assuming the interest payments go into the sweep account that pays 1.55%, which CD yields the most considering the compounding of the interest in the sweep account? Similarly, 3 year CDs at 2.85% pay interest semiannually, and 2.80% pay interest monthly. Which has the higher yield?
When comparing, are you looking at yields or what the distributions are. Yields assume that the coupons can be invested at the same rate as the bond. In other words, a bond with a 3% yield that pays monthly assumes that the coupons can invested in a similar security earning 3%. This is often not the case and is a component of 'reinvestment risk'. This is one reason some people like zero coupon bonds.

So, if those are your two options go with the 2.65% 2 year CD.
Brokered CDs have no provision for reinvestment of interest. The interest is paid to your sweep account. So, they pay simple interest at the quoted rate. However, in the cases cited above, some pay monthly and some semiannually.

venkman
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Re: Brokered CD Interest Compounding

Post by venkman » Thu Apr 19, 2018 9:43 pm

sport wrote:
Thu Apr 19, 2018 10:39 am
Vanguard has 2 year CDs at 2.65% that pay interest semiannually and 2.60% that pay interest monthly. Assuming the interest payments go into the sweep account that pays 1.55%, which CD yields the most considering the compounding of the interest in the sweep account?
On a $10,000 investment, the annual difference between the 2 CD's would be $5, if they paid on the same schedule.

For the 2.6% CD, the cumulative extra interest you would earn from the $21.67 that got deposited into your 1.55% MM account each month works out to well under a dollar, over a period of 6 months.

My conclusion: The 2.65% is better, but not enough to really matter, in the grand scheme of things. :happy

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LadyGeek
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Re: Brokered CD Interest Compounding

Post by LadyGeek » Thu Apr 19, 2018 9:50 pm

sport wrote:
Thu Apr 19, 2018 10:39 am
Vanguard has 2 year CDs at 2.65% that pay interest semiannually and 2.60% that pay interest monthly. Assuming the interest payments go into the sweep account that pays 1.55%, which CD yields the most considering the compounding of the interest in the sweep account? Similarly, 3 year CDs at 2.85% pay interest semiannually, and 2.80% pay interest monthly. Which has the higher yield?
Let's setup this Time Value of Money problem correctly. See the wiki: Comparing investments (Periodic interest rate)

You are asking: Which investment has the higher APY (annual yield)? Example 5 in the wiki article shows how to use the EFFECT() spreadsheet function.

For the 2 year CDs:
I = 2.65%
N = 2 (2 payments / year)
2.67% =EFFECT(2.65%,2)

I = 2.60%
N = 12 (12 payments / year)
2.63% =EFFECT(2.6%,12)

For the 3 year CDs:
I = 2.85%
N = 2
2.87% =EFFECT(2.85%,2)

I = 2.80%
N=12
2.84%=EFFECT(2.8%,12)
venkman wrote:
Thu Apr 19, 2018 9:43 pm
...For the 2.6% CD, the cumulative extra interest you would earn from the $21.67 that got deposited into your 1.55% MM account each month works out to well under a dollar, over a period of 6 months.
This calculation uses the CUMIPMT() function. See: "APR versus APY" in the same wiki article.

Update: Interest paid to a separate money market account is simple interest, not compound interest. See my post below.
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welderwannabe
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Re: Brokered CD Interest Compounding

Post by welderwannabe » Fri Apr 20, 2018 6:40 am

sport wrote:
Thu Apr 19, 2018 8:19 pm
Brokered CDs have no provision for reinvestment of interest. The interest is paid to your sweep account. So, they pay simple interest at the quoted rate. However, in the cases cited above, some pay monthly and some semiannually.
Yes, I am aware of that. I just wanted to make sure that you understood that quoted yields from brokers make the assumption that you are able to reinvest your coupons in some sort of investment vehicle that pays the same rate. This is often not the case, so your actual yield may be less (or more if it is an old bond with lower coupons). Just something to keep in mind.

Here is a little snipped from Investopedia that is a little more articulate than myself:
Reinvestment risk is more likely when interest rates are declining and affects the yield to maturity of a bond, which is calculated on the premise that all future coupon payments will be reinvested at the interest rate in effect when the bond was first purchased.

Read more: Reinvestment Risk https://www.investopedia.com/terms/r/re ... z5DDCWy2ck
I am not an investment professional, but I did stay at a Holiday Inn Express last night.

mouses
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Re: Brokered CD Interest Compounding

Post by mouses » Fri Apr 20, 2018 7:07 am

welderwannabe wrote:
Fri Apr 20, 2018 6:40 am

Yes, I am aware of that. I just wanted to make sure that you understood that quoted yields from brokers make the assumption that you are able to reinvest your coupons in some sort of investment vehicle that pays the same rate. This is often not the case, so your actual yield may be less (or more if it is an old bond with lower coupons). Just something to keep in mind.
Now I'm confused. Say, for example, I see CD foo listed as term one year 2.5% pays semiannually in the Vanguard list, and I buy a $10,000 foo CD. At six months, do I get $125? At one year do I get $125? Or do I get something different?

RickBoglehead
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Re: Brokered CD Interest Compounding

Post by RickBoglehead » Fri Apr 20, 2018 7:21 am

I find this discussion interesting.

I just bought multiple CDs from Vanguard. I fully expect to receive the interest rate stated.

For example, I bought a 2 year CD for 2.65%. I fully expect, every 6 months, to receive $10,000 x .0265 /2. That's 2.65% simple interest. I expect no compounding.

The post about assuming that you invest the proceeds in the same rate each time you get them is I think wrong. If the proceeds were invested in the same rate once received, then the yield would be above 2.65%.

This differs from a yield calculated off the market value of the CD once purchased, because the value of the CD goes up and down, like a bond, so the fixed interest it pays affects the yield since it's calculated off that varying price. I plan on holding all until maturity.

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LadyGeek
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Re: Brokered CD Interest Compounding

Post by LadyGeek » Fri Apr 20, 2018 8:24 am

I just realized that my previous post was wrong, as the CD is paying simple interest. The interest is not reinvested back into the CD, but into a money market account.

If the interest was reinvested back into the CD, it would be compound interest ("interest on interest"). Instead, the compound interest is on the money market account.

Since I made this mistake, so might others. I have revised the wiki to clarify this important point: Brokered CDs

Please review. Comments / questions / corrections are welcome.

Also see:
- Vanguard - Information on CDs
- CDs - Certificates of Deposit - Fidelity - does not mention where the interest payments go.
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trueblueky
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Re: Brokered CD Interest Compounding

Post by trueblueky » Fri Apr 20, 2018 12:19 pm

I have been thinking, ceteris paribus, that a CD with monthly interest payments is marginally better than a CD with semi-annual payments.

Example:
$100,000 CD @ 2.4% paid monthly is $200 each month.
$100,000 CD @ 2.4% paid semi-annually is $1200 twice a year.
Interest is the same $2400/year.

In the first, the first $200 goes into the settlement account and makes a little interest for the five months until the first pay out from the semi-annual CD. ($.83 if the settlement account pays 1%). The second interest payment from the monthly CD gets that 1% for four months, etc. Altogether, $2.50 in six months, without further compounding.

Is that incorrect?

RickBoglehead
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Re: Brokered CD Interest Compounding

Post by RickBoglehead » Fri Apr 20, 2018 12:31 pm

Yes.

In the OP's example, a 2.65% 2 year CD through Vanguard with semi-annual payments, or a 2.60% 2 year CD with monthly payments.

$100,000 @2.65% paid semi-annually is $1,325 every 6 months.
$100,000 @2.60% paid monthly is $216.67 a month. That's $25 short as compared to the higher rate.

At 1.8% (Vanguard Prime Money Market), compounded daily, that $216.67 earns $1.64 in 5 months. The next payment earns $1.29 in 4 months. No matter how you do the math, you're not going to find $25 in 6 months. Therefore, the 2.65% paid twice a year is better than the 2.6% paid monthly.

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Re: Brokered CD Interest Compounding

Post by Alan S. » Fri Apr 20, 2018 5:55 pm

Note that in addition to interest implications, for larger CDs affected by the FDIC limit you can purchase a larger brokered CD paying out periodic interest payments than you could with a bank CD which reinvests interest.

Roughly, at today's 3 year CD rates you would have to hold the bank CD purchase to around 230k to avoid breaching the 250k FDIC limit late in the term. Conversely, with a brokered 3 year CD you can purchase 250k less the coupon payment and the CD would never exceed the FDIC limit.

sport
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Re: Brokered CD Interest Compounding

Post by sport » Fri Apr 20, 2018 10:09 pm

Alan S. wrote:
Fri Apr 20, 2018 5:55 pm
Note that in addition to interest implications, for larger CDs affected by the FDIC limit you can purchase a larger brokered CD paying out periodic interest payments than you could with a bank CD which reinvests interest.

Roughly, at today's 3 year CD rates you would have to hold the bank CD purchase to around 230k to avoid breaching the 250k FDIC limit late in the term. Conversely, with a brokered 3 year CD you can purchase 250k less the coupon payment and the CD would never exceed the FDIC limit.
Alan,
In my experience, a direct CD investor has the option to reinvest interest payments, or receive them in cash. Perhaps this is not always the case.

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