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You may be leaving money on the table when it comes to certificates of deposit, some research suggests.
CDs have a set term, ranging from a few months to five or more years. Upon maturity, banks return the depositor’s principal plus interest.
Consumers who want their money early must generally pay a penalty, losing out on months of interest. However, paying that withdrawal penalty may be worthwhile for many savers who adopt the right strategy.
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That’s what is suggested in a recent research paper from Matthias Fleckenstein, associate professor of finance at University of Delaware, and Francis Longstaff, finance professor at the University of California, Los Angeles.
Rather than pick a short-term CD, consumers often get a higher return by choosing a long-term CD and paying a penalty to pull money out early, they found.
Consumers who are unaware of the strategy may get “shortchanged” by banks, Fleckenstein told CNBC.
‘The rule rather than the exception’
Here’s an example: If an investor puts $1 in a five-year CD with a 5% interest rate and cashes it out after one year with a penalty equivalent to six months of interest, they would receive about $1.03, which is slightly more than the $1.01 they would get from a one-year CD with a 1% interest rate, despite the penalty incurred for early withdrawal.
Banks frequently price CDs this way, Fleckenstein and Longstaff wrote in their paper, published in October in the National Bureau of Economic Research.
The researchers examined weekly CD rates offered by 16,891 banks and branches — ranging from small community banks to big nationwide institutions — from January 2001 to June 2023. Rates were for accounts up to $100,000.
About 52% of CDs offered during that period had such “inconsistencies” in pricing when comparing a given term against a longer-term CD cashed in early, they found.
“It’s the rule rather than the exception,” Fleckenstein said.
“There are banks that do this all the time,” he said, and “there are some that don’t do this at all.”
At banks where this happens, the difference in returns “is not tiny,” Fleckenstein said. In fact, the pricing inconsistency is about 23 basis points, on average, over the roughly two decades they assessed, he said.
Given that disparity, the average investor who invested $50,000 could have gotten an extra $115 of interest by picking a longer-term CD and cashing it in early, their research suggests.
The average size of that pricing difference rose as interest rates began to increase during the Covid-19 pandemic, Fleckenstein said.
CDs often for ‘safety and liquidity’
Households that save in CDs are generally looking for “safety and some liquidity” for a chunk of their assets, said Winnie Sun, co-founder of Irvine, California-based Sun Group Wealth Partners and a member of CNBC’s Financial Advisor Council.
The typical CD buyer has a goal in mind, like saving for a home down payment, and wants to earn a modest interest rate without subjecting their money to much risk, Sun said.
About 6.5% of households held assets in CDs as of 2022, with an average value of about $99,000, according to the most recent Survey of Consumer Finances.
Like any investment, there are pros and cons to CDs.
For example, unlike other relative safe havens like high-yield savings accounts or money market funds, CDs offer a guaranteed return over a set period with no chance of market-based losses. In exchange, however, CDs offer less liquid access to your cash than a savings account and lower long-term returns than the stock market.
“Shop around for the best CD rate across banks, but also look within banks at whether it actually may pay off to accept a longer term but pay an early withdrawal penalty,” Fleckenstein recommended, based on his research findings.
The option may not be as prolific in the current market environment, though.
Long-term CDs typically pay a higher interest rate than shorter-term ones, Sun said. But average rates for one-year CDs are currently higher than those for five-year CDs: 1.7% versus 1.4%, respectively, according to Bankrate data as of Jan. 20.
Households can pursue other CD strategies, Sun said.
For example, instead of putting all savings into a long-term CD, consumers might put a chunk of their money into a long-term CD and with the remaining funds build a “ladder” of shorter-term CDs that mature more quickly. They can then buy more CDs if they’d like once the shorter-term ones come due.