Maximize GIC Returns by Carefully Considering the Annual Rates Before Locking In Long Term

Let’s consider again why one bank wanted to renew my GICs by locking them in for a five-year term, admittedly to the product with the best average annual return over the life of the product.

Here’s a comparison of several offerings from CIBCs website (on October 28, 2012)
None can be cashed before maturity. All are for an investment of $1000:

  • a 1-year GIC, pays 0.900%
  • a 1-year Bonus Rate GIC, pays 1.1%
  • a 3-year GIC, pays 1.25%
  • a 3-year Bonus Rate GIC, pays 1.45%
  • a 5-year GIC, pays 1.75%
  • a 5-year Bonus Rate GIC, pays 1.9%
  • a 3-year Escalating Rate GIC, pays 1%, 1.1% and 2.55% (effective yield 1.5475%)
  • a 5-year Escalating Rate GIC, pays 1%, 1.35%, 1.75%, 2%, 4.05% (effective yield 2.0043%)

And that’s not all of the GIC products they are offering!

Notice the “Bonus” Rate
First, you can see that you can get .2% more for a 1 or 3 year term GIC just by buying the Bonus Rate version instead of the regular version. You might get even more if you phone. Buyer beware!

Notice the Increasing Rate
Next, you can see that CIBC expects interest rates to increase over the next 5 years. If they expected rates to decrease, their long term certificates would pay the same or less than their short-term certificates.

Notice the Cunning Marketing Tactic
You can also see a marketing tactic in the Escalating Rate GICs. They offer a very high rate (comparatively) for the final year of the product to catch the buyer’s eye. If you look at the effective yield, however, it’s easier to see the low impact of that one year of higher rate.

Quick Guess of Which to Pick
A quick glance at these offerings suggest that your best decision is to lock in for five years in the Escalating Rate product to earn an effective yield of 2.00043%.

Thinking Critically about Future Interest Rates
But it’s time to apply some critical thinking skills.

Everyone from the Bank of Canada to the local free newspaper keeps stating that interest rates are exceptionally low. Everyone seems to agree that rates have to go up, and fairly soon. (I notice they’ve been saying that for two years already though.)

If Interest Rates Will Decrease then Locking In May Earn the Best Return
If you believe that interest rates will not go up in the next 5 years, or will go down, then yes, the 5-year Escalating GIC is the best option on that list.

If Interest Rates Will Increase What Should You Do?
But if you believe that interest rates will go up .5% a year, it’s not best to lock-in to that Escalating Rate 5-year GIC. If rates go up .5% a year, you could make almost $4 more by buying a series of 1-year GICs.

More importantly, a series of 1 year GICs would give you the most flexibility for re-investing that money each year depending on rates and other options.

How Does the Bank Predict Future Interest Rates?
Here’s what the bank may be thinking:To keep it simple, I’ve assumed that no interest is earned on interest (compounding) until the start of a new year.

Invested Rate End of Year 1 Rate End of Year 2 Rate End of Year 3 Rate End of Year 4 Rate End of Year 5
1000 1 1010 1.35 1024 1.75 1042 2 1062 4.05 1105
1000 1.1 1011 2 1031 2 1052 2.5 1078 2.5 1105

The first row is what CIBC was offering for the Escalating Rate GIC, with the eye-catching 4.05% in the final year.

The second row is probably what they are basing their offering on: If the interest rates step up to 2% for 2 years, and 2.5% for 2 years, the total amount earned by the GIC is about the same. But it doesn’t have the eye-catching rate, so it’s harder to market.

Now CIBC is in the business of making as much profit as possible, so if it is offering interest rates per year for the next 5 years of
1.1, 2, 2, 2.5, 2.5

it is likely expecting to have to offer GIC rates for the following 5 years for 1-year GICs at
1.1, 2.25, 2.25, 2.75, 2.75
or higher.

What would that second set of rates earn?

Invested Rate End of Year 1 Rate End of Year 2 Rate End of Year 3 Rate End of Year 4 Rate End of Year 5
1000 1.1 1011 2.25 1034 2.25 1057 2.75 1086 2.75 1116

How Do You Predict Interest Rates?
What if you think interest rates on 1 year GICs will be: 1.1, 2. 2.5, 3, 3.5?

Invested Rate End of Year 1 Rate End of Year 2 Rate End of Year 3 Rate End of Year 4 Rate End of Year 5
1000 1.1 1011 2 1031 2.5 1057 3 1089 3.5 1127

You can see you will lose money if you lock in that Escalating Rate GIC for 5 years if interest rates follow your pattern.

We’re Not Talking Huge $$$ Here
You can see that the total dollar differences between the different scenarios are fairly small.

So why would you lock in for 5 years?

If rates took a high jump, you’d be locked in.

The chance of rates dropping significantly in 5 years seems small. And even if they did, you’d probably be looking at deflation, not inflation, so your money would buy more than it does now.

My Interpretation: Don’t Lock in GICs for Long Terms at Low Rates
My opinion is locking in rates for 5 year terms only makes sense when rates are high and are unlikely to rise any higher. Locking in for long terms when rates are low seems to be a high risk for a low reward.

Related Reading

Join In
Do you agree that it’s unwise to lock in investments for long terms at these rates? Does it bother you that banks use a marketing gimmick to offer a pseudo-high interest rate by only offering it for the final year of a multi-year term? Please share your opinion with a comment.

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