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When does it make sense to pay an early withdrawal penalty?

when_does_it_make_sense_to_payQ: I have a 3-year CD due to mature in nine months. Its APY is just 0.13 percent. I have an opportunity to invest in a 17-month CD at an APY of 0.325 percent. I am assuming the penalty for early withdrawal on the current CD is six months' worth of interest. Would it be a smart move to break into that CD and invest the proceeds in the 17-month CD instead?

A: This is a very timely question because, with interest rates rising, many people are going to find their existing CD rates well below what they could get in today's market. That raises the issue of when it makes sense to break into a CD before its maturity date in order to roll the proceeds into a CD with a higher yield.

Early withdrawal penalties: How to do the math

Here's how the early-withdrawal-penalty math works out under the scenario you describe:

  • Your current CD would yield about 0.0975 in interest over the next nine months
  • The 17-month CD would yield about 0.2437 in interest over those nine months
  • That means the new CD would yield 0.1462 more than the existing one over the next nine months
  • A penalty of 6 months' worth of interest on the existing CD would amount to 0.065 percent
  • Since the new CD would provide more additional interest than the amount of the penalty you face, you would come out ahead by switching.

The one uncertainty about all of the above is that you say you are assuming that the penalty is six months' worth of interest. Check on that before making a move. You might find yourself happily surprised -- some CD penalties diminish as the maturity date approaches.

Shop for the best CD rates

While eating the early withdrawal penalty and switching to a 17-month CD at 0.325 APY sounds like it could be a good move, it probably isn't the best move you could make.

While 17-months is a bit of an odd time period (banks do that occasionally as a promotion), a quick look at the MoneyRates.com CD rates page would find you several 18-month CDs yielding well over 2 percent. In other words, switching to one of the best CD rates available could earn you a lot more interest than what you have in mind.

Consider a CD ladder

Finally, think about whether a 17-month CD meets your needs. Can you afford to tie up the money for that long? Could you commit the money for an even longer period to earn a higher rate?

With rates rising, it might be a good idea to consider a CD ladder. By splitting the proceeds from your current CD into two or more CDs with staggered maturity dates, you could earn higher yields and still have money that becomes available for reinvestment at regular intervals.

That way, if CD rates continue to rise, you would have periodic opportunities to reinvest at higher yields without facing your current dilemma of whether or not to pay an early withdrawal penalty.

Got a financial question about saving, investing or banking? MoneyRates.com invites you to submit your questions to its "Ask the Expert" feature. Just go to the MoneyRates.com home page and scroll down to find the "Ask the Expert" box.


More resources on managing CD investments:

Calculator: Know your CD's inflation-adjusted value at maturity

Is your CD losing value? Read What inflation is doing to your CD rates

Shopping for CD rates? Use our rate-finder tool

How do I ladder my IRA CDs without taxes or penalties?

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