Front page article and Q&A on how interest is paid on term deposits and how to stop yourself from being ripped off.
Front page article
Bank customers are missing out on hundreds and sometimes thousands of dollars of term deposit interest, in a practice that has “outraged” the Consumers Institute’s David Russell.
While banks give customers options about how often interest is credited to their accounts, many customers don’t realise this.
And when customers don’t specify frequent crediting of interest, the banks use their default policies, which can deprive customers of considerable sums.
The longer the term of the deposit, the bigger the loss. If the term is less than a year, the loss will be minimal — unless you have a large sum.
But on a typical five-year $10,000 term deposit, a customer can miss out on $240 — more if they are in a lower tax bracket. On a $100,000 deposit, they can miss out on $2400 or more.
“Most bank front-line staff are trained to offer the crediting and payment options to customers, and explain their impact,” says David Chaston of JDJL Ltd, which recently surveyed banks on their practices.
But Russell and several other financially savvy term deposit holders said they don’t recall being told about the options.
“It should be very, very clearly explained to the customer, at the time they lend the bank their money, what the deal is going to be,” says Russell.
“If you look at the other side of the coin, when the bank lends you money and calculates the interest you pay them, they don’t charge on an annual basis”, but much more frequently.
Here are the major banks’ default policies on term deposits of one year or more:
The ANZ pays interest annually. You can’t leave the interest in the term deposit. It is always transferred to a bank account where it may earn interest, depending on the account.
The ASB pays interest annually. If you leave it in the bank, you will earn interest on that interest — called compounding.
The BNZ pays all interest at the end of the term, without compounding. However, it is planning to contact affected customers in the next couple of weeks to change this.
National Bank pays interest twice a year. If you leave it in the bank, it will compound.
Westpac pays interest quarterly. If you leave it in the bank, it will compound.
The banks do offer other options — on both crediting interest and when you can take interest out.
“Almost all banks will offer compounding arrangements for terms of six months or more, or nine months in some cases, if you ask them,” says Chaston.
However, Westpac is the only major bank that pays different interest rates, depending on how often interest is credited. If it’s credited monthly, the rate is lower than if it is credited less frequently — which reflects the fact that more frequent crediting makes your money grow faster.
Most building societies do not compound interest, Chaston said. But most finance companies do.
In a typical finance company, “interest earned in a calendar quarter is credited to the customer’s account at quarter end.” The customer can then take out the money, but if they leave it in, it will compound.
Many term deposit holders are not affected, or only slightly affected, by this issue. Most deposits run for less than a year, and the BNZ says 90 per cent of its holders take their interest out, rather than leaving it to compound.
Still, with a total of about $69 billion in term deposits — more than $17,000 per man, woman and child — large sums are involved.
“Given many New Zealanders’ quite poor level of financial education, it is likely to be significant,” says Chaston.
What you can do about it? Read on.
QIn 2002 I put $50,000 into a fixed interest account with the BNZ to mature in 2007.
The interest rate was good, or so it seemed at 6 per cent. The problem is that I have belatedly discovered that interest is paid by multiplying the original sum by 6 per cent and then by 5 and paid in one lump sum at maturity.
As a result the rate of interest on a compounded basis is a lot lower than 6 per cent, and in gross terms I am nearly $2000 down on what I had anticipated.
Do banks have a requirement to present interest rates on a comparable basis or not?
Obviously the longer the term the worse the picture and the lower the true rate of interest quoted should be.
I appreciate there are tax considerations, and on a 39 per cent tax rate the after tax difference is less than $1000. But for low-rate taxpayers the impact would be large and I feel most unfair.
And I think you are being generous to the bank. Your calculation that you are nearly $2000 down, before tax, assumes your interest could have been compounded each year.
If you use quarterly compounding, the difference is almost $2350.
To the BNZ’s credit, though, spokesman Owen Gill said yesterday that it plans to remedy the situation. “We’re working on isolating which customers are affected, and trying to get in touch with them in the next couple of weeks.”
I hope you’re happier soon.
Other banks, however, also treat customers the way you were treated.
In answer to your question about whether banks have to offer interest rates on a comparable basis, Graham Gill of the Commerce Commission says, “No”.
“But they need to disclose how their interest rate is calculated. Under the Fair Trading Act, they couldn’t provide information likely to mislead the customer.”
He adds, however, “If the customer didn’t ask, they might not have been misled.”
Predictably, David Russell of the Consumers Institute is stroppier. “They can be misleading by what they don’t say as much as what they do say. If there’s considerable significance and potential to mislead by not saying something, they may be caught under the Fair Trading Act.”
Banks do have to give you an investment statement if you take out a term deposit, says Liam Mason, general counsel for the Securities Commission. And “investment statements can’t be misleading or confusing.”
But they don’t have to be particularly specific.
“Because interest rates move, and banks do have different payment options, the investment statement will just have to say something along the lines of: ‘Interest will be paid at the rate and frequency set out in the rate card or as agreed with our customer.’.”
The statement should describe how to find out interest rates. “That tends to be, ‘Talk to the bank staff.’.” says Mason.
Not everyone is hurt by infrequent compounding. If you are taking the interest out as it is paid, you are not affected.
And if you expect your tax rate to be lower at the end of the term — perhaps because you will be out of the work force or retired — you might be better off with a term deposit that pays all interest at the end.
The same might also apply — especially to those in higher tax brackets — if the bank offers higher rates to those who receive all their interest at the end.
For everyone else, though, the more frequently you receive interest, the faster your money will grow.
What can people do about the situation?
- If you’ve already got a long-term deposit on which interest is not compounding frequently, and you’re with the BNZ, wait to be contacted soon. If you’re with another bank, yell.
Banks have been known to change what they do — partway through an investment, mortgage or whatever — if they want to keep the customer happy.
Unsurprisingly, this is especially true for wealthier customers.
- Before getting a new term deposit, “The depositor should make an active choice of: (a) how often interest is credited and (b) how often it is paid out — subject of course to the options offered by the institution,” says David Chaston of JDJL Ltd.
www.interest.co.nz includes information from most financial institutions on how often term deposit interest is credited and how often you can take the interest out.
If you want to make your own calculations for different interest rates and different compounding, you can use the compound interest calculator on www.moneychimp.com.
Here’s how to allow for resident withholding tax:
If you are in the 19.5 per cent tax bracket (taxable income of less than $38,000), multiply your interest rate by 0.805, and use that rate in the calculator.
For those in the 33 per cent bracket (taxable income of $38,000 to $60,000), multiply your interest rate by 0.67. Those in the 39 per cent bracket should multiply their interest rate by 0.61.
Too hard? Basically, you want high interest and frequent compounding — whilst being aware that finance companies tend to pay higher interest but are riskier.
If all else fails, you can always invest for short periods and then reinvest your principal and interest. That way, you will get compounding. Note, though, that you may receive lower interest for tying up your money for shorter periods, which might offset the advantage.
- Lobby the banks to get them to change their default policies.
“In my opinion,” says Chaston, “the bank default policies should be changed to where the arrangements are for interest to be credited on the most frequent option offered, and paid at the end of the agreed term.”
Mary Holm is a freelance journalist, a director of the Financial Markets Authority and Financial Services Complaints Ltd FSCL, a seminar presenter and a bestselling author on personal finance. Her opinions are personal, and do not reflect the position of any organisation in which she holds office. Mary’s advice is of a general nature, and she is not responsible for any loss that any reader may suffer from following it. Send questions to [email protected] or click here. Letters should not exceed 200 words. We won’t publish your name. Please provide a (preferably daytime) phone number. Unfortunately, Mary cannot answer all questions, correspond directly with readers, or give financial advice.