Economic Replacement Value (ERV) For CD’s
November 6, 2008 – 5:05 am
I remember radio commercials from my childhood that advertised certificates of deposit (CD’s). At the end of each commercial the announcer would very quickly say “substantial penalty for early withdrawal.” Later in life I discovered that this was a lie, or at least my idea of “substantial” was different from others.
Certificates of deposit are savings vehicles that lock in a rate of return for a specific period of time. The money that is invested supposedly is tied up for the entire duration of the CD, and therefore cannot be quickly converted to cash. If you shop around CD’s usually pay more than savings accounts and money market funds. This makes sense because the CD buyer is taking more risk (interest rate risk) and is giving up flexibility compared to other investments. Therefore the return should reflect this added risk.
I’ve never purchased a CD that spanned more than 18 months, but I have been watching the CD rates lately. As I was reviewing capital one’s current CD rates I noticed something new, at least to me, in the fine print. Capital one uses a graduated “penalty” schedule for early withdrawal. For a CD that is for less than 6 months, the penalty is 1 months’ interest. For a 6mo – 1yr CD the penalty is 3 months interest. If the term of the CD is 1 year or more, things get tricky: the penalty becomes the greater of 6 months interest and the Economic Replacement Value (EVR).
Hurray. I new financial acronym! 
According to the Capital One fine print, EVR is essentially a calculation that adjusted for rising interest rates and supposedly covers the bank if you decide to withdrawal some or all of your principle from the CD early.
Example
Say you purchase a 5-year CD at 5% for $10,000 and 6 months into the CD you need to withdrawal the entire amount due to a job loss. By that time interest rates have gone up substantially. The EVR calculation for Capital One would go something like this:
1. Calculate the interest rate difference between your CD and the next closest maturity without going over, which is 4-years if Capital One doesn’t offer a 4.5-year CD. We’ll assume the 4-year CD has a 6% APY
6.0% – 5.00% = 1.00%
2. Multiply the % from step 1 by the principle amount withdrawn.
1.00% * 10,000 = $100.
3. Multiply this amount by the number of years your original CD has left to maturity.
$100 * 4.5 years = $450
4. 6 months of interest would be $250. Therefore, since $450 is greater than $250, your penalty for early withdrawal would be $450. Of course that’s only IF interest rates jumped that much AND you needed to withdrawal the entire $10,000.
What does it all mean?
- Read the fine print before you purchase a CD. Banks are finding new ways to insulate themselves from risk and charge higher fees if unexpected things occur.
- Depending on your needs a CD may offer you a higher rate of return with minimal downside risk. For example saving for a medium term goal, like a house five years from now or a car in three years, may be a good use for CD’s. You’ll get a higher return than a savings account (IF you shop around). And if worse comes to worse and your car dies early you can probably redeem your CD’s early and only cost you a few percent of your investment.
Image Credit: the mad LOLscientist
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