By Jeff Johnson
Early withdrawal penalties are designed to be a deterrent to members from withdrawing their certificates of deposit before the maturity date. In the current low interest rate environment, the penalties most credit unions impose may not act as the deterrent they were intended to be.
Early withdrawal of a CD usually happens when the early withdrawal penalty does not outweigh the benefit of reinvesting in a new CD with a higher rate, a member is not satisfied with earning a lower return on a CD as compared to other investment options, or an unforeseen circumstance arises and cash is needed. The risk associated with the first two reasons increases when rates are low, and can increase even more when rates stay low for a long period of time.
The ability to rely on certificates of deposit for a fixed period is central to asset and liability management. It is important to be aware of the risk many credit unions currently have in their certificates of deposit, especially in a rising rate environment, and to know what options are available to mitigate this risk.
We are currently in a period where rates on certificates of deposit are very low. These low rates can be beneficial for credit unions if they can lock in member deposits.
[minimal_table]
| National Average CD Rates as of July 31, 2015 | |
| 3 Mo CD - $10k | 0.19% |
| 6 Mo CD - $10k | 0.29% |
| 1 Yr CD - $10k | 0.45% |
| 18 Mo CD - $10k | 0.54% |
| 2 Yr CD - $10k | 0.68% |
| 30 Mo CD - $10k | 0.78% |
| 3 Yr CD - $10k | 0.93% |
| 4 Yr CD - $10k | 1.17% |
| 5 Yr CD - $10k | 1.45% |
[/minimal_table]
However, most credit unions are not prepared to deter members from early withdrawal of their certificates of deposit should even a relatively small increase in rates occur. Common penalties for early withdrawal of CDs are 3-12 months’ interest, usually dependant on the term of the CD. If a member is yielding 0.5% on a certificate of deposit with only one year left until the maturity date, it does not take much of a rise in interest rates for an early withdrawal to be beneficial. With a penalty of 3 months' interest, it would only take a rise of greater than 0.125% in rates for it to be beneficial for early withdrawal and reinvestment.
[minimal_table]
| Penalty on $10,000 CD | Current Yield | Penalty | % Rise in Rates to Break Even, Assuming One Year Left on Deposit |
| 3 months’ interest | 0.50% | $12.50 | 0.125% |
| 6 months’ interest | 0.50% | $25.00 | 0.25% |
| 12 months’ interest | 0.50% | $50.00 | 0.50% |
[/minimal_table]
A majority of credit unions have an average weighted maturity on their certificates of deposit of greater than one year and have CDs paying less than 0.5%. Both would require an even smaller rise in rates before it is beneficial for the member to early withdraw. In an interest rate environment where CD yields are higher, it takes a much larger rise in rates before the benefit outweighs the penalty. Let’s look at two examples to illustrate this effect:
At a current yield of 0.5%, an increase above 0.125% has the potential to drive an early withdrawal.
If that current yield is 3%, however, it now takes an increase greater than 0.75% to drive that early withdrawal.
[minimal_table]
| Penalty on $10,000 CD | Current Yield | Penalty | % Rise in Rates to Break Even, Assuming One Year Left on Deposit |
| 3 months’ interest | 3.00% | $75.00 | 0.75% |
| 6 months’ interest | 3.00% | $150.00 | 1.50% |
| 12 months’ interest | 3.00% | $300.00 | 3.00% |
[/minimal_table]
Historically it has been common to estimate early withdrawals of certificates of deposit at 3-5% annually. When rates eventually rise, we may assume this percentage will increase dramatically.
This increased risk when rates are low can be mitigated by changing the structure of the penalty on early withdrawals of certificates of deposit. Here are some alternatives that can help ensure your penalties will actually deter early withdrawals more evenly in various rate environments.
Make the penalty a percentage of the CD – This is the most common alternative to using a specified number of months’ interest. Some financial institutions only make the penalty on the amount withdrawn from the CD and not the whole amount of the CD.
Make the penalty a flat fee – This option is more straightforward, but does create a disparity in the percentage of the penalty for differing amounts deposited.
Make a minimum penalty – The minimum penalty does not have to be a flat fee. It could also be based on a percentage of the CD.
Almost all financial institutions allow the penalty to take some of the principal of the deposit, but it may be vital to some members that the penalty is capped at the amount of interest earned. It is important to evaluate your credit union membership to determine the best option or hybrid of options for your credit union.
Using one of these alternative options decreases the estimated risk early withdrawal presents when in a low interest rate environment. The rise in interest rates needed for the member to benefit by early withdrawing remains the same whether current yields are 0.5% or 3%.
[minimal_table]
| Penalty on $10,000 CD | Current Yield | Penalty | % Rise in Rates to Break Even, Assuming One Year Left on Deposit |
| 2% of CD | 0.50% | $200.00 | 2.00% |
| $100 Fee | 0.50% | $100.00 | 1.00% |
| Penalty on $10,000 CD | Current Yield | Penalty | % Rise in Rates to Break Even, Assuming One Year Left on Deposit |
| 2% of CD | 3.00% | $200.00 | 2.00% |
| $100 Fee | 3.00% | $100.00 | 1.00% |
[/minimal_table]
You should consult with legal counsel or your compliance officer before enacting any penalty structure.
There may be a lot more risk in certificates of deposit than one may think. Credit unions should evaluate their own certificate of deposit portfolio and see what risk even small rises in interest rates pose. Credit unions should also determine how much of a rise in interest rates it takes for a given percentage of CDs to benefit from an early withdrawal. These early withdrawal risks and alternative penalty options need to be considered as part of proper asset and liability management.
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