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No Penalty CD: How does it work

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No-penalty CDs offer a distinct advantage: higher CD rates without the long-term commitment.

time-is-moneyPutting your money in a certificate of deposit usually involves a trade-off: the longer you commit your funds, the higher the interest rate a bank is willing to offer.

But a growing number of banks are offering no-penalty CDs - breakable CDs that effectively give you the best of both worlds (higher CD rates without the long-term commitment).

If you are considering investing in a CD, you should learn about no-penalty CDs before you commit your money.

What is a no-penalty CD?

A no-penalty CD is like a regular CD, offering high interest rates in exchange for your commitment to leave your money on deposit for a specific period of time - except that it doesn't penalize you if you need to break your commitment and pull money out early.

This can give consumers a big advantage, because early withdrawal penalties can be expensive.

What happens if you withdraw early?

Most certificates of deposit are issued for a specific term, or period of time, that ranges from a few months to five years. If you sign up for a one-year CD, for example, you are expected to keep your money on deposit in that CD for the entire year or else pay an early withdrawal penalty.

The average penalty on a 1-year CD

MoneyRates.com research found that the average penalty on a 1-year CD is 142 days' worth of interest. (That would be nearly five months of interest down the drain.)

With a $10,000 balance, you would earn $111.35 in interest over the 1-year term. But the average penalty for breaking a 1-year CD would cost you $65.09 - or more than half your interest.

The average penalty on a 5-year CD

On 5-year CDs, the penalties are even harsher. The average penalty is 333 days' worth of interest, so you would lose about 11 months' worth of earnings.

The penalties tend to be even steeper for high-yielding CDs; so on average, breaking into a 5-year CD early could cost you more than a year's worth of interest. The average 5-year CD with a $10,000 balance would pay $155.72 in annual interest, and the average early withdrawal penalty would set you back $167.64.

With a no-penalty CD though, you are allowed access to your money before the term is up without paying the penalty. As the above figures show, this lack of a penalty can really help.

No-penalty CD terms

BankCD NameCD Term (in months)Traditional / Online
Marcus by Goldman SachsNo Penalty CD7Online
Ally BankNo Penalty CD11Online
CIT BankNo Penalty CD11Online
Marcus by Goldman SachsNo Penalty CD11Online
CitibankNo Penalty CD12Traditional
S and T BankPenalty Free CD12Traditional
Marcus by Goldman SachsNo Penalty CD13Online
Old Line BankNo Penalty CD13Traditional
Ridgewood BankPenalty Free CD15Traditional

[Note: This study was completed on July 17, 2019. Product terms may have changed. Please visit each bank's website for current information.]

How to compare no-penalty CDs

As you can see from the table above, no-penalty CDs come in a variety of lengths. Rates change frequently too. So how do you compare them with each other, and with the alternative of a CD that does have an early withdrawal penalty?

There are two characteristics that are generally true of these no-penalty CDs:

  1. They generally have fairly short terms.

    MoneyRates.com found that the longest term of a no-penalty CD was a 15-month CD, and most of the terms are around a year. This means that no-penalty CDs are not really an alternative to long-term CDs, but can be thought of best as alternatives to CDs in the 6-months-to-1-year range.

  2. No-penalty CDs often have irregular time periods, such as 7, 11 or 13 months.

    This may seem to make them harder to compare to the standard CD lengths of 3 months, 6 months or a year until you remember that you can break into no-penalty CDs at any time. That means you can compare them to any CD of similar length or shorter.

Lean toward long-term, no-penalty CDs

Because of these characteristics, when you look at no-penalty CDs, you should lean toward a CD with the longest term you can find. That is because they are likely to pay the highest interest rates; and if you can break into the CD at any time without penalty, there is no harm in choosing a longer term.

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

Comparing no-penalty CDs with conventional CDs

  1. Consider yield

    Suppose you were thinking of a 1-year CD. There would be no reason not to consider the 13- and 15-month products listed in the table if they offer the best yields, because you can always shorten the term to suit your needs without penalty.

    So if a no-penalty CD offers a better yield than a conventional CD you were considering, you could choose the no-penalty CD even if it were for a longer time period than you had in mind.

  2. Consider how likely you are to break into a conventional CD

    But how do you weigh the two options if a CD with a penalty has a higher yield than a no-penalty CD?

    In that case, you have to consider how big a chance there is that you would break into the CD early. The earlier you might do that, the greater the advantage of a no-penalty CD.

Compare leading CD rates from other banks

What happens if you withdraw early: penalty vs. no-penalty CDs

The chart below shows two high-yielding CDs of approximately one year in length. The Sallie Mae CD has a higher yield but an early withdrawal penalty, while the Marcus by Goldman Sachs CD has no penalty.

The table shows how much interest you would earn net of the early withdrawal penalty if you took out your money in less than one year and if you kept it in for the full year:

Compare-Rates-and-Banks

As you can see, despite a slightly lower yield, the Marcus by Goldman Sachs CD has an advantage if you take your money out in less than a year. Only by keeping your money in for the full term and avoiding a penalty could you reap the full advantage of the higher yield on the Sallie Mae CD.

Therefore, this kind of choice comes down to how certain you are that you will be able to leave your money in the CD for the full term. The more you think you might have to take the money out earlier, the better a no-penalty CD would look.

Why would you break a CD?

Under what circumstances would you break a CD by withdrawing money early?

Two situations force the decision to break a CD:

  • You need money immediately
  • You can get a better interest rate

In terms of a need for money, some needs are predictable and some are unpredictable. Both might cause you to break a CD early.

Predictable needs

Starting with a predictable need, let's say you know you will need money for a down payment on a home in six months. You could still consider a longer term CD if:

  • The extra interest you would earn in six months exceeds the penalty you would pay for breaking the CD, or
  • The CD had no early withdrawal penalty

In those cases, a predictable need could cause you to plan on breaking a CD early.

Unpredictable needs

Of course, many financial needs are unpredictable. Therefore, when you commit to a CD, you have to consider how big a chance there is you would have to break into the CD early and how big a penalty you would pay if you do.

If there is a low chance of an unexpected financial need arising, you can confidently commit to a longer term. Also, if the certificate of deposit has no early withdrawal penalty, there is no downside to breaking it early if you have to.

That just leaves the other type of situation when you might break a CD - for example, when you have been shopping for CD rates and you know there's a better rate elsewhere.

When to break a CD for higher rates

Suppose you committed to a one-year CD and, in three months, you find CD rates have risen. What do you do?

If you have a no-penalty CD, the answer is easy. You can simply break your current CD and sign up for a higher yielding CD.

If interest rates rise and you have a CD with an early withdrawal penalty, the answer is more complicated:

  • You have to calculate how much extra interest you could earn in a higher yielding CD over the remaining term of your current CD, and then compare that to the penalty you would pay if you broke into your CD early.

Only in periods of sharply rising interest rates is it likely to make sense to break a CD with a penalty in order to switch to a higher yielding CD. However, a no-penalty CD gives you the option of making that switch even for more normal interest-rate increases.

With no-penalty CDs, it is still important to make sure they offer a fairly competitive interest rate. If that is the case, then the flexibility they give you in case of unexpected needs or rising interest rates give them a special advantage over conventional CDs.

What are no-penalty CDs best for?

Here are some examples of good uses for a no-penalty CD:

1. Emergency funds

By nature, emergency funds are designed to cover unexpected expenses. Normally, the drawback of using a CD in an emergency fund would be the early withdrawal penalty. However, a no-penalty CD removes that concern.

2. Expenses with uncertain timing

Suppose you are shopping for a house. You could put your down payment money in a no-penalty CD even before you know when it will be needed, since there is no cost to accessing the money at any time.

3. Rising interest-rate environments

A risk of locking up money in a CD is that you could potentially miss out on a higher return if interest rates rise during the term of the CD. With a no-penalty CD, you could take your money out at any time and reinvest it in a higher yielding CD if rates rise during the CD's term.

These are just some examples of the best uses for a no-penalty CD. Generally, any situation where you might need immediate liquidity but want a higher yield than a savings or money market account would be a good fit for a no-penalty CD.

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