The Washington area has become the latest battleground over interest rates with local banks and savings and loan associations advertising returns as high as 36 percent in an effort to attract new depositors.
At stake is a portion of the estimated $250 billion Americans are expected to deposit in the new tax-free All Savers Certificates approved by Congress last month. The certificates go into effect Oct. 1.
In an effort to sign up customers before Oct. 1, financial institutions in some parts of the country have been offering interest rates as high as 40 percent as bait to get new customers in their doors. New York's Chase Manhattan Bank, for example, told investors in a two-page newspaper advertisement it could put $650 in their pocket right away if they invest $20,000 now.
Three area lending institutions opened similar advertising campaigns earlier this week. Several more area institutions are launching campaigns this weekend with rates up to 36 percent.
The catch is that the 30 percent or 40 percent interest rate only remains in effect from now until Oct. 1 when the effective annual rate will be reduced to around 12 percent. The bonus interest is taxable; the lower rate on the All Savers certificate is not.
The higher initial rate is made possible through the use of retail repurchase agreements, also known as repos. These are technically loans that savers make to financial institutions that are supposedly backed by securities owned by the institutions. Because they are not considered deposits and are not insured if the institution fails, there is no federal ceiling on the interest rate that can be paid on repos. All Savers certificates, on the other hand, are insured and interest rates on them are regulated.
Chase Manhattan took the pains to explain all this in its advertisement yesterday in two pages of bold face type. But most of its New York competitors just highlight the bonus rates in their advertisements. A few of them added to the confusion by telling customers they could pull out their funds before Oct. 1.
But confusion over the repo rate is only half the story. There is also confusion on the part of banks and savings institutions over rates and penalties, as well as confusion in the minds of individual savers as to whether the tax-exempt certificate is advantageous for them.
The law specifies that the All Savers certificate must have a yield equal to 70 percent of the investment yield on 52-week Treasury bills. The method of calculating this has not yet been finally determined by federal financial regulators. When it is, the Treasury, as an aid to consumers, will publish the rate.
The difference between the discount rate, the coupon equivalent yield and the investment yield on Treasury bills can be substantial. For example, at the last 52-week bill auction Aug. 7, the discount rate was 14.542 percent; the coupon equivalent, 16.6 percent, and the effective annual yield, 17.29 percent. The coupon equivalent yield should be used when comparing Treasury bills to other types of investments like certificates of deposit and money market funds. To calculate the All Savers tax-free yield, take 70 percent of the investment yield.
Also to be decided is the question of penalties. The law states only that if the certificate is cashed early or pledged as collateral for a loan, the taxpayer loses his or her exemption. Moreover, one cannot deduct interest on a loan to purchase a tax-free certificate. The law does not prohibit financial institutions, however, from levying their own additional penalties, such as a three-month forfeiture of interest. Many ads refer to additional penalties in the fine print without defining them. Another question mark is whether financial institutions will permit consumers to roll over their existing certificates into tax-exempt certificates without premature withdrawal penalties.
These issues are expected to be resolved next month by the Depository Institutions Deregulation Committee in time for the Oct. 1 kickoff. Those who invest now to take advantage of the bonus offered could have some unpleasant surprises.
Another confusing question is whether a person is better off buying a tax-exempt certificate or putting his or her money in a higher yielding, taxable account. This depends on the individual's tax bracket. Here again, the ads have been of marginal help. Some illustrate their rates by showing gross income and assuming 20 percent itemized deductions, while others show taxable income after deductions. Persons whose deductions are atypical should use taxable income charts whenever possible.
Also, various institutions use different base rates on which to compute yields. This week, for example, New York banks were building charts on tax-exempt rates ranging from 9.8 percent to the 11.97 percent used by Chase Manhattan and based on the latest 17.29 percent investment rate. The actual rate won't be known until after the next one-year T-bill auction next month.
The simplest example is of a person or couple in the 50 percent tax bracket. A tax-free yield is the equivalent of a taxable yield twice as big. Chase's 11.97 percent yield equals 23.9 percent to someone in this bracket. Thus for them the tax-exempt certificate is a better buy than a six-month certificate yielding 17 percent or a money market mutual fund, yielding about 17.2 percent this week.
The break point -- the point at which it is more advantageous to purchase a tax-exempt certificate than a taxable investment -- is at the 32 percent tax bracket. For married couples filing jointly, that means a gross income of more than $36,125. For singles that means a gross income of over $20,875. Or a taxable income for marrieds of over $30,000.
Adding the bonus payment gives an effective interest rate of just over one percentage point more over the one-year life of the certificate, raising the yield from 13 to 14 percent.
By buying a tax-exempt certificate now that outstrips other investments, the customer locks in the yield for 13 months. If interest rates go down in the meantime, the certificate holder comes out ahead.