Why Your Local Bank Offers Low Interest Rates - They Know You Probably Aren't Going to Leave
How Purchasing CDs in an Investment Account Can Complement Your Local Bank Accounts
Ever wonder why your local bank pays so little interest on savings, checking, and CDs? The reason is your bank knows that customer assets on deposit are sticky. Convenience is a contributing factor to stickiness, though, in a digital world, there are few occasions in which one actually needs to physically visit a local branch. A larger and economically rational reason for keeping one's local bank account is that it is a hassle to set up new accounts, especially if you have established automatic deposits and/or use automatic bill-payment features of your checking accounts.
Innate loyalty is a third factor that tends to make consumers willing to accept below-market interest rates from their local banks. This loyalty is often not bilateral, as it is common practice for local banks to offer higher rates to new depositors than to existing customers. In this article, I will explain the many benefits of purchasing CDs through investment accounts while still keeping your local checking and savings accounts. First, however, it is important to understand the difference between CDs distributed through investment firms (“Broker-ed CDs) and CDs that are purchased through banks.
Bank CDs vs. Brokered CDs
There is a common misperception among consumers that CDs issued through one’s local bank are somehow safer than CDs purchased through an investment firm. That is simply not true. In both institutions, CDs are FDIC-insured and, as such, offer a guarantee of interest and principal if held to maturity (subject to the FDIC coverage limits).
One fundamental difference applies to how each is handled if the consumer elects to redeem a CD early. With most bank CDs a percentage or interest penalty is applied. With a brokered CD, there is no penalty, but the redemption value is marked to market at the time of redemption. This means that if interest rates have risen since the CD was issued, the owner may get less than the face value if redeeming early. If interest rates have fallen, the owner may actually receive more than the face value upon redemption.
Another difference is in the manner in which interest accrues. In most bank CDs interest accrues in the CD and compounds until maturity. The same is true for most brokered CDs with maturities of less than 12 months. For longer maturities, brokered CDs are structured similarly to bonds and typically pay out interest every six months or sometimes monthly.
Consumers should be aware that some brokered CDs have call features that allow the issuing bank to redeem the CDs at face value prior to maturity. Call features are never a benefit to consumers. Conversely, a unique feature of most brokered CDs is a “death put” provision that allows the CDs to be redeemed prior to maturity at face value upon the death of the account owner.
3 Advantages of Purchasing CDs Through an Investment Account Instead of a Bank or Credit Union
- Higher Interest Rates – Hundreds of banks use the brokered CD market to raise capital to both make additional loans and to maintain federal bank deposit requirements. It is not uncommon for the CD rates that local, regional, and national banks are offering their in-branch customers to be more than 1% lower than the rates the same banks are offering through the brokered CD market.
- Enhanced FDIC Coverage – while account registration (e.g., IRA, joint name, individual, trust, corporate, etc.) and the number of beneficiaries determine the FDIC coverage at a local bank, within an investment account, it is possible to have virtually unlimited FDIC coverage by allocating one’s money across multiple banks.
- Simplified Tax Reporting – At your local bank or credit union, you must set up a new account for every CD you own. Each account generates its own 1099-INT at the end of the year. In contrast, consumers may purchase multiple CDs from multiple banks within a single investment account with interest reported to the IRS on a single consolidated 1099. In my opinion, this is one of the most underrated benefits of purchasing CDs in investment accounts.
But What About Local Convenience and the Hassle of Changing Bank Accounts?
As noted earlier, proximal convenience and the time and energy required to change automated deposits and bill payments are legitimate, rational reasons for consumers to maintain accounts with their local banks and credit unions. Fortunately, there is a way to have your cake and eat it too. At Financial Planning Hawaii, we encourage all clients to establish electronic transfer links (also called ACH links) to their like-named local bank accounts. These links allow for on-demand bi-directional fund transfers between accounts. Transfers are typically completed in 1-2 business days.
As you can see, in the digital age, there are not many rational reasons to keep large amounts of money in bank accounts that pay little or no interest. Similarly, there are even fewer reasons why individual consumers or businesses should ever keep more than the FDIC insured limit in ANY account.