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Illustration: Chiara Ghigliazza
Bank customers often opt for short-term certificates of deposit rather than higher-yielding long-term CDs because they are leery of potentially incurring early-withdrawal fees if they need their funds before the term is up. That is often a mistake.
In many cases, according to new research, investors would be better off choosing longer-term CDs and paying an early-withdrawal fee if they need the money before the CD reaches maturity.
That is because most banks—intentionally or unintentionally—have “internal inconsistencies in their deposit pricing,” meaning that their interest rates on shorter-term CDs yield less than those on a longer-term CD, even with an early-withdrawal penalty, according to study co-author Francis A. Longstaff, a finance professor at UCLA.
How it works
In a simple example, a bank customer wants to invest $10,000 for one year, and the bank offers a 1% rate for a one-year CD and a 4% rate for a two-year CD. With the one-year CD, the customer receives $10,100 after one year.
But if the customer had invested in the two-year CD and withdrew the investment after one year, paying an early-withdrawal penalty of, say, six months of interest, the customer would receive $10,400, minus the $200 fee, which is $10,200.
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If the pricing were consistent, the return on a two-year CD that was closed after one year would be the same as the return on a one-year CD at maturity.
“Clearly, the customer would be better off with the two-year CD, even if it means paying the early-withdrawal fee,” Longstaff says.
To arrive at their findings, researchers analyzed data from S&P RateWatch, which tracks CD interest rates and early-withdrawal fees from more than 96,000 bank branches in the U.S. The team obtained weekly data from Jan. 5, 2001, to June 30, 2023, on CDs that would mature in six months, one year, two years, three years, four years and five years.
The study found that in 52.4% of the CD term structures, there was at least one shorter-term CD whose interest rate was “dominated” by a longer-term CD, meaning short-term investors would get proportionately lower returns, Longstaff says.
Not by chance?
Longstaff says the obvious question is whether banks are intentionally shortchanging investors who lack financial sophistication and reflexively opt for short-term CDs to avoid early-withdrawal fees. Researchers note that 11.81% of banks in the sample had zero CD price inconsistencies over more than two decades, suggesting that those institutions actively avoid shortchanging investors with short-term CDs.
Conversely, 8.36% of the banks offered only term structures that were internally inconsistent, and an additional 11.72% offered inconsistent pricing at least 90% of the time. Meanwhile, 35% of banks had pricing inconsistencies between 50% and 80% of the time, according to the study.
“The probability of these results occurring by chance appears very unlikely and suggests that the internal inconsistencies in their term structures may be deliberate,” the researchers wrote.
When CDs reach their maturity date, many banks automatically roll over that money into new CDs with similar terms unless the customer opts out. In doing so, banks may be locking customers into new CDs with less-favorable interest rates or early-withdrawal penalties than they could get elsewhere, the study finds.
Nick Fortuna is a writer in Ocala, Fla. He can be reached at reports@wsj.com.
