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#49076 - 12/16/02 09:47 PM Pre-Paid Interest CD
ATreas Offline
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ATreas
Joined: Jun 2002
Posts: 27
Pennsylvania
Our Marketing Department is trying to find ways to promote certificates of deposit without increasing interest rates.
They would like to advertise an 11 month CD that would pay the interest in advance. In other words, the depositor could open a CD and walk out of the bank that same day with a check for 11 months worth of interest. Disclosures would explain penalties, etc for early withdrawals.

I've never heard of this being tried before. Does anyone know of a regulation that would prohibit the advance payment of interest on a certificate of deposit?

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#49077 - 12/16/02 10:01 PM Re: Pre-Paid Interest CD
BANNED BY BOL MANAGEMENT Offline
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BANNED BY BOL MANAGEMENT
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I don't know of anyone that would want to try this scenario. The yield increases with the payment of interest up-front (present value of money) and tax would be due up-front when interest is paid. I don't think that there are any regs that cover this, except if you make a payment that compounds when there is no compounding taking place. The APY would be impacted by an up-front payment, so you should look at that issue.

Please let us know if anyone actually buys this product.

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#49078 - 12/16/02 10:11 PM Re: Pre-Paid Interest CD
John Burnett Offline
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John Burnett
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Cape Cod
Check on this with the IRS, but I think this scenario says the interest is constructively received at maturity (like a T-bill). As long as it's for under one year you don't have to report OID annually.

The APY is larger because you treat the discounted amount as the amount deposited (principal less interest). The concept is just like prepaid finance charges on a loan.
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#49079 - 12/16/02 10:12 PM Re: Pre-Paid Interest CD
rlcarey Online
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rlcarey
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Posts: 83,227
Galveston, TX
Don't go over a 1 year term - or you will have an OID on your hands and the IRS reporting requirements. You may want to do a search on this. I know there a several threads out there that have discussed before.
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#49080 - 12/16/02 10:30 PM Re: Pre-Paid Interest CD
BANNED BY BOL MANAGEMENT Offline
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If customers physically receive the interest, they will have to report the interest when received, correct? T-bills don't pay interest up-front, they are discounted with the payment at maturity.


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#49081 - 12/17/02 12:56 PM Re: Pre-Paid Interest CD
Elwood P. Dowd Offline
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Next to Harvey
No regulations would prevent you from doing what you propose. However, as noted above, you need to work through information reporting and Regulation DD disclosures.

I agree with the consensus that your product does not pull the trigger for OID reporting. Interest would be reported on a 1099INT in the year it is paid.

In candor, I don't believe OID reporting would be required/allowed regardless of whether the original maturity was more than 12 months. The relevant OID trigger talks about time deposits with original maturities of more than 12 months where interest is paid only at maturity. The second requirement is missing from your scenario; your proposed practice is not what the IRS was trying to regulate. OID reporting is intended to make the taxpayer recognize the "calendar year" as the period for paying taxes and eliminate the possibility of tax deferral by using favorable investment terms. Payment of interest at the inception of an 18 month time deposit accelerates taxation - a result the IRS would not find fault with. Please note, your customer would love it if you could use OID reporting; e.g. I got all the interest in 2002, but don't have to pay taxes on part of it until 2003. Dream on.

As for the APY, I'm less confident about responding without sitting down and doing some test calculations. So, I will offer only a couple observations, the second of which is tentative. First, once the balance is established, only two things affect the APY, the interest rate and the frequency of compounding. Prepayment of the interest eliminates the concept of compounding; paying interest on interest is mechanically impossible. So, it looks like a simple interest disclosure. However, what balance is to be used as the basis for the APY calculation? My best guess is to agree with John, it is the amount invested, minus the amount receieved in advance as interest. As that choice, rather than simply the amount invested, increases the APY, I would want to think it through carefully.
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#49082 - 12/17/02 01:12 PM Re: Pre-Paid Interest CD
Richard Insley Online
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Richard Insley
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Toano, VA
Ken, I agree with your observation about the APY formulas taking no account of time value. The Fed chose this screwy math when it wrote Reg. DD and rejected industry recommendations to apply the familiar (although complex) formulas from Reg. Z. Since advance payment of interest and bonuses do not fit into the APY formulas adopted, these pricing elements become meaningless in the marketplace.
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#49083 - 12/17/02 05:08 PM Re: Pre-Paid Interest CD
rlcarey Online
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Galveston, TX
I guess I have to disagree with your assessment that an 18-month CD that "pays the interest upfront" would not be considered an OID. I did not have time to research all the IRS revenue rulings, but the mere fact that the customer gives you a check for $1,000 and you immediately hand him/her a check for $100 does not negate the fact that its original issue/acquisition price is $900, no matter what spin you put on it.

As a couple of side notes, what type of early withdrawal penalties would you contemplate and will you start with a negative interest accrual and work up?
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#49084 - 12/18/02 12:35 PM Re: Pre-Paid Interest CD
Elwood P. Dowd Offline
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Elwood P. Dowd
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Next to Harvey
On reconsideration, I think the principal amount used in the APY calculation would be the original amount contributed without adjustment for the prepaid interest. I agree in advance with anyone who says that makes no sense. However, reducing the principal amount by the amount of prepaid interest is our logical attempt to "fix" Appendix A to Regulation DD to allow for the time value of money. We don't have the power to do that.

Also, I said there would be no compounding. That is correct in the mechanical sense, but the APY formula, in converting the calculation to 365 days, would assume compounding occurs just as it does on any other time deposit with an original maturity of less than 365 days

Random neural firings on early withdrawal penalties and other key terms:

The instrument would be disclosed as a single maturity with no interest paid after maturity. (If you make it automatically renewable with interest payable at the inception of the next term, a grace period is a practical impossibility; you already mailed the interest check.)

The APY quoted would have to be comparable to rates on time deposits of similar terms in order to make the pre-payment of interest a selling point that would entice the depositor. (APY calculations do not factor in the time value of money, but reality does. It would be easy for the bank to price this deposit too high.)

The disclosure regarding the date of interest accrual would indicate that all interest is accrued at the date of inception. The disclosure on the forfeiture of accrued interest if the account is closed might be omitted as irrelevant; there is no accrued interest after the date of inception. Nevertheless, I would probably spell that out in the disclosure.

The disclosure regarding compounding would be omitted as irrelevant. The disclosure regarding crediting of interest would indicate that interest is paid at inception.

As rlcarey's question implies, an early withdrawal penalty based on a specific period; e.g. 3 months, 6 months does not make any sense - you already paid 11 months interest up front. You would have to structure the penalty in such a way that you recover enough of the interest to make you whole plus an increment for liquidated damages. In effect, the amount of the penalty would have to grow during the life of the instrument and, at some point, substantially exceed the amount of interest paid in advance. Rather than create an appropriately fluid and necessarily complex early withdrawal penalty, I would just disclose that no early withdrawals are allowed.

Out of my league, but essential to your planning is some analysis of how this will distort the bank's earnings.

Note: This is an electronic brain storming session on a product none of us have ever seen and should be given that amount of credibility.

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