In an intriguing financial revelation, a study has unveiled that long-term certificates of deposit (CDs) typically offer higher interest rates than their short-term counterparts, but with a twist. The research, which examined data from 16,891 banks and branches between January 2001 and June 2023, found that banks frequently create pricing inconsistencies in CD offerings. These inconsistencies can lead to significant differences in potential returns for investors. As of 2022, approximately 6.5% of households held assets in CDs, averaging around $99,000 per household, highlighting the importance of understanding these financial instruments.
CDs are financial products with set terms ranging from a few months to five or more years. They traditionally promise higher returns for longer commitments. However, the study revealed an average pricing inconsistency of 23 basis points over the examined period, with the discrepancy widening as interest rates increased during the Covid-19 pandemic. This inconsistency means consumers may not always receive the expected higher returns for longer-term investments.
The research highlighted that about 52% of CDs offered during the study period exhibited pricing inconsistencies when comparing a given term against a longer-term CD cashed in early. Currently, average rates for one-year CDs stand at 1.7%, surpassing those for five-year CDs, which offer only 1.4%. This trend underscores the irregularities in CD pricing and the need for consumers to be vigilant when choosing where to invest their money.
Early withdrawal from a CD generally incurs a penalty, resulting in lost interest. This penalty can be substantial, potentially negating the benefits of choosing a longer-term CD if cashed in prematurely. Despite this risk, the study found that the average investor who placed $50,000 in a longer-term CD and withdrew early could have earned an additional $115 in interest compared to sticking with a shorter-term CD.
Matthias Fleckenstein, an associate professor of finance at the University of Delaware and a key researcher in the study, emphasized the commonality of these pricing inconsistencies. He stated:
"It's the rule rather than the exception." – Matthias Fleckenstein
Fleckenstein advises consumers to carefully evaluate their options:
"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." – Matthias Fleckenstein
The typical CD buyer often has specific financial goals in mind, such as saving for a home down payment or securing funds for future use while earning modest interest without exposing their money to significant risk. CDs offer a sense of safety and liquidity, making them an attractive option for risk-averse investors.
With household investments in CDs standing at approximately 6.5% as of 2022, it is evident that many individuals seek stability and reliable returns. However, understanding the intricacies of CD pricing is crucial to maximizing potential earnings.