The penalties of term deposits

By Simon Wang

October 06 2019
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With the increased volatility in investment markets, many investors and savers have gravitated towards term deposits as their preferred haven of safety and liquid cash. The rates on term deposits look attractive when compared to the current cash rate of 0.75 per cent in Australia, but life is full of unexpected events, and there are times when you will want to withdraw funds before the term deposit matures, when you experience a cash-flow problem or some other financial emergency, writes Simon Wang.

In this article, we look at the penalties for withdrawing your term deposit before your maturity term is up, and compare this to investing in a fixed income fund which offers the same daily liquidity, diversification and the potential for higher returns without the harsh penalties of a term deposit.

The two main penalties for withdrawing a term deposit early are the need for a 31-day advance notice to the bank, and the prepayment interest adjustment to your interest rate, which is typically based on how long a term you have left until the maturity of the term deposit. You may also incur an administration fee. So, if you need the funds from your term deposit urgently, you essentially have your liquidity locked up for 31 days, and also incur an adjustment to your interest rate and an administration fee, depending which financial institution you have your term deposit with.

While some institutions may not have the 31-day lock-up, they all apply a similar prepayment interest adjustment. It’s also worth noting that minimum balance limits often apply to term deposits. So, even if you are only withdrawing a partial amount, if this reduces your account balance below the minimum limit, your account could be automatically closed and the interest rate reduction could apply to the entire balance.

We will also take a look at the impact on your supposed interest earnings based on if you needed to pull out your funds before maturity for a term deposit compared to investing in a fixed income fund. We will use the simplified example of Commonwealth Bank’s prepayment adjustment to interest rates shown in Table 1 below.

Table 1: Prepayment adjustment to be applied

Percentage of term elapsed	Adjustment to be applied as a percentage of your interest rate
0% to less than 20%	90%
20% to less than 40%	80%
40% to less than 60%	60%
60% to less than 80%	40%
80% to less than 100%	20%

As an example, if your funds are invested for half of the agreed term (six months out of a one-year term deposit), the prepayment adjustment to be applied will be 60 per cent.

If the current agreed interest rate when you opened the term deposit was 2 per cent per annum, the interest rate you will earn on the amount that you have withdrawn early will be 40 per cent of the interest rate agreed at the start of the term, in this case 0.8 per cent per annum (that interest rate is lower than the current Reserve Bank cash rate).

Let’s assume you have $100,000 invested in a 12-month term deposit and you wish to withdraw the entire amount. If you waited until maturity, you would earn $2,000 interest. However, if you withdrew your funds halfway (six months) into the term, you would be penalised with the rate adjustment and a $30 administration fee, instead earning only $770 interest. This would also only be if you notified the bank 31 days in advance before being able to pull your money out. There is no legal requirement for the financial institution to break your term deposit early, even if you request for this to happen.

So, while investors often consider term deposits a safe investment, that perceived safety generally comes at the cost of low returns, poor liquidity and severe penalties for early withdrawal. There are better options available.

Simon Wang is a senior credit analyst with Daintree Capital.

Disclaimer: Please note that these are the views of the writer and not necessarily the views of Daintree Capital. This article does not take into account your investment objectives, particular needs or financial situation.

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