Risks and Benefits of Long-Term Certificates of Deposit

As I've mentioned several times this year, long-term CDs can be much better deals than short-term CDs even if you think interest rates will rise substantially in the next year or two. If interest rates stay low, the long-term CDs are better since the interest rates are much higher than short-term CDs. If interest rates rise substantially, you can close the long-term CD early. You'll be hit with an early withdrawal penalty, but for many banks and credit unions, the early withdrawal penalty is mild. With a mild early withdrawal penalty, the long-term CD closed early can return more than short-term CDs that you hold to maturity. It can also be better than just keeping your money in a savings account.

Two institutions which have competitive long-term CD rates and mild early withdrawal penalties are Ally Bank and Pentagon Federal Credit Union. Last week I reviewed their rates for both cases: 1) if the CDs are held to maturity, and 2) if the CDs are closed early.

As I mentioned in that post, there are two risks with this long-term CD strategy:

1. The bank refuses to allow an early withdrawal
2. The bank increases the early withdrawal penalty on your existing CD

Some banks include in their disclosures the right to refuse an early withdrawal request. For the second risk, it's not as clear. When we first learned of Ally Bank's early withdrawal penalty of only 60-days of interest, several readers were informed by Ally bank reps that Ally had the right to change the early withdrawal penalty on existing CDs with 30-day notice. I investigated this, and received assurance from Ally Bank's public relations director that Ally would not change the early withdrawal penalty on existing CDs (see post). A reader looked into this issue with Fort Knox FCU, and its compliance office claimed it held the right to change the early withdrawal penalty on existing CDs with just a 30-day notice. The concern is if one institution can make such a claim, other institutions in the future might also make this claim. If inflation and interest rates shoot up in a year or two, banks will have a big incentive to assert such a claim to prevent customers from withdrawing their money from their low-yield CDs.

I've worked with Allan Roth of the CBS MoneyWatch The Irrational Investor blog on this issue. Allan has done a well-researched post, CDs as Bond Bubble Protection - Revisited. On the question of whether an institution can change CD terms, such as the early withdrawal penalty, he received opinions from an attorney and spokespersons from the FDIC and NCUA. All had the opinion that the institution would not be able to "unilaterally change the early withdrawal terms." However, the reader who first looked into this topic thinks the issue is still muddy since the disclosures have terms that appear to give the institutions blanket allowance to make changes with a 30-day notice.

One thing that is clear is when the institution states in the disclosure that an early withdrawal can only be made with their consent. In those cases, you could be stuck in the CD until maturity. As Allan mentioned in his post, it's very important to read the CD disclosure before you open the account. Also, you should keep a copy of the disclosure.

As I mentioned in this previous post, there have been reported cases of banks making use of this type of clause and preventing customers from making early withdrawals. If interest rate shoot up in the future, we may see more of these cases.