Certificate of Deposit Penalties: When Paying the Price Can Be Worth It

The wide spread between short-term and long-term rates on certificates of deposit leaves you with a dilemma. Do you accept a low CD interest rate so that you can get at your money before too long, or do you lock up your money longer in order to earn more interest? Sometimes, the spread between short-term and long-term CD rates is so wide that it pays to get creative.

The alternative course would be to accept the penalty for early withdrawal from a longer-term CD--if that penalty is smaller than the additional interest you would earn by choosing a longer-term CD.

CD Interest Rates Today

These days, if you decide to keep your money short-term in a 6-month CD, you'd be hard-pressed to earn more than a 1.75% annual rate of interest. On a 5-year CD, you can find offers in the 3.25% to 3.5% range. In other words, 5-year CD rates are just about twice as big as 6-month CD rates.

So, would it be worth investing in the higher-yielding CD and accepting the penalty if you had to withdraw before the end of five years? That depends on the penalty.

Types of Penalty

When it comes to figuring out whether it is worth paying an early withdrawal penalty, CD buyers have to be careful because the nature and size of these penalties vary greatly. Here are some ways banks assess these penalties:

• Days of interest. This seems to be the most common form of early withdrawal penalty. Since interest rates vary all the time, the bank may not express the penalty as a fixed amount of interest, but rather as a certain number of days' worth of interest. The key to how significant this penalty is to compare the number of days' penalty to your planned holding period. The greater the portion of your holding period the penalty represents, the less likely it will be worthwhile to pay that penalty.
• Fixed percentage. Some banks will charge you a fixed percentage of your original deposit for early withdrawal. The key here is how much total interest you will earn over your holding period, and how much of that the penalty will wipe out.
• Set dollar charge. Another form of penalty is expressed as a set amount of dollars. In this case, the size of your deposit is a key factor. These set dollar penalties can be large percentages of small deposits, but may represent a more manageable amount of larger deposits.

Note that with all of the above types of penalties, if you withdraw too soon it is possible that they will not only wipe out your interest, but could eat into principal as well.

There are also some variations on these penalties. Some banks offer a limited window for readjusting your CD rate if market rates rise sufficiently. This may be a good solution if your concern about locking into a longer-term CD is not so much needing access to the money, but possibly missing out on a rise in interest rates. Still other CDs let you withdraw without penalty under certain circumstances.

So does it make sense to accept an early withdrawal penalty in order to earn a higher CD interest rate? You'll only know after you read the fine print, and do the math.

Source:

Discover Bank: http://fb.discoverbank.com/campaigns/products/dynamic/cd/12months/200906/index.aspx

Gail Liberman & Alan Lavine • Twelve tips to get the best rates on bank deposits • Aug 04, 2009 • marketwatch.com • http://www.marketwatch.com/story/twelve-tips-to-get-the-best-rates-on-bank-deposits-2009-08-04?siteid=rss&rss=1

Gail Liberman & Alan Lavine • Family Finances: High-interest CD ads may be ploys • Jul 17, 2009 • post-gazette.com • http://www.post-gazette.com/pg/09198/984490-68.stm?cmpid=business.xml