How would you design a better CD? You can't design it to be better for just the depositor. It has to be a win-win for both the depositor and the bank. That's what Neil Stanley has been working on. In his article at Banking Strategies, From Commoditized to Customized Deposits, he describes ways CDs can be improved so that banks can attract and retain depositors. He warns banks that CDs are declining in popularity, and this decline isn't just due to the low interest rate environment. Offering more customized CDs will allow banks to attract more deposits without offering the highest interest rates.
One interesting feature Stanley proposes is an early withdrawal that would be similar to the gain/loss an investor would experience when selling a bond or a brokered CD:
* Have the option to withdraw early from the time deposit with all principal and interest and a “bond-like” gain when interest rates have dropped
This feature has already been implemented in a direct CD at one Iowa bank. Treynor State Bank offers a CD that is called CDtwo. Here's how the bank describes the early withdrawal penalty/bonus:
After the first 7 days, the penalty/bonus is determined by the Replacement Fee. The Replacement Fee is an estimate of the interest cost to us if we were to replace a CD that is withdrawn early with another deposit having a term that is comparable to the remaining term of the original CD. 18 month - 60 month terms available. If interest rates have risen, then the cost of the new deposit will be higher. If interest rates have fallen, then the cost of the new deposit will be lower.
One thing nice about this feature is that the bank is upfront about the early withdrawal. There's no assumption that the depositor will hold deposits until maturity. So depositors shouldn't have to worry about a bank refusing an early withdrawal request or surprising depositors by changing the costs of early withdrawal on existing CDs. Two credit unions have already increased early withdrawal penalties on existing CDs. The worry is that we may see more of these actions when interest rates go up.
Another nice thing about this feature is that it could provide a bonus for an early withdrawal when rates have fallen. This is similar to what some banks have done in the last few years by temporarily waiving early withdrawal penalties on existing CDs. In these cases, the banks are hoping to close the "expensive" CDs. For depositors in this case, the only reason you would want an early closure would be if you have an immediate need for the money.
The downside with this feature that I see is that the replacement fee is more complicated than the typical early withdrawal penalty. The typical EWP is often just 6 months of interest on the amount withdrawn. That's easy to understand, and it's easy to calculate the consequences of early withdrawals.
What do you think of this early withdrawal feature? And what CD features would you like to see from banks and credit unions?
Edit 4/8/13: Removed "Refinance conventional CDs" bullet.