Borrowing on CDs to invest at higher yields: there are some risks

There's an old saw: "Look at problems as opportunities." In the world of fluctuating interest rates, long-term certificates of deposit are a problem. Many people have thousands of dollars trapped in 6 1/2 to 8 percent long-term CDs. Whether to redeem them early, pay the penalty, and hope to earn enough to compensate for the loss continues to trouble readers. Already this column has examined the economics of cashing CDs early and reinvesting the proceeds. With a short time to maturity, it's usually best to leave the money alone.

Now, a reader suggests an alternative approach -- an opportunity to make money from a long-term CD. It would work like this:

Suppose you had $10,000 invested in a seven-year CD at 7 1/2 percent interest compounded daily with a maturity date one year ahead. You could go to your bank or S&L and borrow against the CD, using it as collateral. Usually, since there is no risk, a lender will lend you the full value of the CD and charge 1 to 3 percent above the rate -- 7 1/2 percent in this example. A 2 percent margin is typical. Thus, you could raise $10,000 at an interest cost of 9 1/2 percent -- not compounded. Immediately, you invest the $10,000 in a money market mutual fund at, say, 14 percent and earn a 4 1/2 percent differential.

Using this example, your $10,000 CD would earn $778.76 for the year. Your loan would cost $950, which is deductible as interest if you itemize. Your net out-of- pocket cost would be $171.24 for interest. A money market mutual fund paying an average nominal 14 percent compounds earnings daily. At this rate you would earn $1,502.43 on the $10,000 for one year. Subtracting the out-of-pocket interest, your net return would be $1,502.43 less $171.24, or a net of $1,331.19 -- taxable as ordinary income.

But consider the following:

* Yields on money market mutual funds vary daily and could easily skid to something less than the average of 14 percent in this example. Since future yields are not guaranteed, you would need to watch the fund closely.

* Money market mutual funds are not insured. You would be trading the security of an insured CD for a slightly higher-risk money fund investment.

* Not all banks or S&Ls will lend money on a CD as security. Other banks or S&Ls will lend only 80 or 90 percent of the face value of the CD. "For personal reasons" will usually suffice when asked about your intentions.

* You are liable for the loan regardless of what happens to your money fund investment. The bank or S&L is protected, because it can offset your loan against the collateral. Of course, you may prefer to use the money to modernize your house, send a son or daughter to college, or for some other purpose. You could plan to pay off the loan when the CD matures. But if this is your plan, recognize that you are spending an asset.

Borrowing low-cost money for investment to return a higher yield is not new. Millions of people with cash-value insurance have been borrowing against their policies, paying 5, 6, or 7 percent interest on the loans and reinvesting those funds at double or higher rates. They earn the difference in yields, and it makes good sense financially to use money to make money.

Borrowing against long-term CDs is not limited to $10,000, as in this example. Whatever funds you have trapped in long term, low-rate CDs could be used for collateral as long as you can put together the minimum deposit for a money market fund -- t ypically $1,000.