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Intermediate And Long-Term CDs – Interest Rate Risk Protection?

January 12, 2012

Rates are low and, given news from the Fed, expected to stay low for the time being.  Some members are taking the Fed at their word and are beginning to move their funds into intermediate and longer-term CDs.  Before assuming this can help provide interest rate risk protection credit unions should answer a few questions.

CDs come with an early withdrawal penalty, but are your penalties enough to keep members from withdrawing their funds if rates move up? Consider the following example:

A credit union is offering a 5-year CD at 2% with a 6-month early withdrawal penalty.  One year after a member takes this CD, rates have increased.

Question:  How high would rates have had to increase over this year to put the member in a position to take the early withdrawal penalty and break even?

Answer:  Rates would have had to increase just 25 basis points (bps).

If the member takes the CD out early, they are charged a 1% penalty.  However, the member still has a 4-year investment horizon, which, if they can earn an extra 25 bps per year, equals the 1% penalty taken to pull their funds out early.  If rates increase more than 25 bps then it is a “no-brainer” for the member.  Some say that their members won’t early withdraw because they are fee adverse, but after years of pent up demand for more yield, it is hard to bet that the member won’t withdraw.  If there is a small fee to get a mortgage, does it stop someone from refinancing to a lower rate?

If the credit union is happy that it at least got the funds from the 6-month penalty, consider that the 2% rate minus the 6-month penalty results in a net cost to the credit union of 1% for what wound up being a 1-year CD.  1% for a 1-year CD is rather expensive for the credit union if there is not corresponding loan demand.

If rates don’t change, the member will continue to receive 2%, costing the credit union more than most investments would yield without taking substantial risk.

Credit unions do a lot of great things for members.  The key in this difficult environment is to make sure that the areas of giveback are intentional and understood.  Without such understanding, costs and risks can unintentionally increase.

What can be done if you decide that it isn’t in the credit union’s best interest to add an additional giveback?

Consider not trying to be top of the market on intermediate and longer-term CDs.  Some credit unions have increased the penalties on intermediate and longer-term CDs.  Eighteen months or half of the term are examples.  You could have the stiffer penalties for your current CD rates and offer lower rates for members that want the flexibility of a lower penalty.

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