CD rates Blog

Finance Blogs » CD rates » CDs are like piggy banks

CDs are like piggy banks

By Sheyna Steiner · Bankrate.com
Thursday, May 30, 2013
Posted: 12 pm ET

Banks and other financial intermediaries are like piggy banks, according to a recently revised paper from the Federal Reserve Bank of New York titled "Piggy banks: Financial intermediaries as a commitment to save."

Products such as certificates of deposit essentially lock funds out of reach, which reinforces the commitment to save for some people. The function of locking money away essentially forces some savers to hang onto their money rather than spend it right away. You may not have ever considered that one of the basic functions of your financial institution is to take money out of your pocket and hold onto like a stern parent, but that's exactly what institutions do with penalties and bank fees for withdrawing money early from a CD.

The paper deals with some of the trade-offs between consumption, short-term investing and long-term investing, and some of the solutions. One real-world example is the callable CD.

Callable CDs give banks a prepayment option. That is, they can pay off before the stated maturity date. The option may exist only for the first year of the contract or until maturity. Bankers' decisions on whether to call a CD and the CD holders' spending will depend on market rates. If market rates fall relative to the initial CD rate, banks will tend to call CDs and the holders will tend to spend more rather than roll over their savings at lower CD rates. If market rates rise, banks will be less inclined to call CDs, and the holders will postpone consumption.

If everyone considered money in purely rational ways, they would always demand high illiquidity premiums in return for locking money up for a period of time. But, the paper concludes that the illiquidity premium doesn't need to be as high as one might think because some people just need a barrier to spending.

Though not a lot of people are buying them lately, I'd bet that the piggy-bank function is one of the main reasons for CD purchases these days. What do you think? Does it help to have barriers to spending?

Follow me on Twitter: @SheynaSteiner.

***
Senior investing reporter Sheyna Steiner is a co-author of "Future Millionaires' Guidebook," an e-book written by Bankrate editors and reporters. It's available at all the major e-book retailers.

«
»
Bankrate wants to hear from you and encourages comments. We ask that you stay on topic, respect other people's opinions, and avoid profanity, offensive statements, and illegal content. Please keep in mind that we reserve the right to (but are not obligated to) edit or delete your comments. Please avoid posting private or confidential information, and also keep in mind that anything you post may be disclosed, published, transmitted or reused.

By submitting a post, you agree to be bound by Bankrate's terms of use. Please refer to Bankrate's privacy policy for more information regarding Bankrate's privacy practices.
Add a comment

(Comments may take 5-10 minutes to appear)