Learn more about CD penalties and how to avoid them.
Why CDs Charge Early Withdrawal Penalties
The bank wants you to keep your money invested for a set period, which may be six months or a year, or even perhaps five years. It’s willing to pay you a higher interest rate return if you do so. The bank benefits from having certainty about how long it can use your money. Banks and credit unions typically charge penalties for early CD withdrawals. That’s because they use the money you deposit into CDs to lend to other customers and buy investments that have maturities, much like CDs. If you demand your money early, the bank might have to pay its own form of penalty elsewhere. In that case, you might have no choice but to pay a penalty to the bank if a withdrawal is your only option.
Early Withdrawal Penalty Examples
Banks typically charge a penalty that amounts to a portion of the interest you would have earned if you had held the CD to maturity. You might see it quoted as “90 days of interest” for early withdrawal. There’s no maximum penalty amount, so read the fine print. A sample penalty schedule for early withdrawal might look like this:
11-month CDs or shorter charge three months’ interest12- to 59-month CDs charge six months’ interest60-month CDs or longer charge 12 months’ interest
For example, suppose you have a 12-month maturity CD that you cash out in the 11th month. You’ll probably walk away with more than you initially put into the CD—although not as much as it could have been had you held off for one more month. Continuing with this same example, suppose you were to cash out after two months. You haven’t yet earned the six months’ interest as required by the penalty schedule. However, the bank will still take that amount by deducting it from your initial investment deposit. This action is called “invading the principal.”
How To Avoid CD Early Withdrawal Penalties
If you absolutely must cash out early, look for a way to avoid penalties. First, it never hurts to ask. The staff might waive the penalty for you, particularly if it’s an emergency and if you’re at a friendly institution or a smaller credit union. Otherwise, all they can do is say no. You can usually qualify for a waiver for death, disability, court-determined incompetence, and other major life events. In those types of cases, speaking directly with a representative is particularly important. Banks are permitted to offer these waivers, but that doesn’t necessarily mean that they will. They’re not required to do so by law.
‘Liquid’ No-Penalty CDs
Liquid CDs are similar to standard CDs, but they work more like traditional savings accounts in that they allow you to pull money out early. Sometimes, liquid CDs have limits as to how early and how much you can withdraw, and you might have to make at least a minimum deposit, but they’re worth investigating. Your “locked in” period is relatively short with these CDs—less than a week in many cases. Still, no one would invest in traditional CDs if this option were that easy. Since you have more flexibility, you’ll receive a lower interest rate in exchange for this freedom.
Alternative CD Strategies
You can try to use other flexible options to avoid penalties when you’re tucking your money away in the future. CDs aren’t bad options, but there might be better alternatives if you find that you keep having to pay penalties.
CD Ladders
Laddering CDs is a strategy where you’ll periodically have one of several CDs mature, often on a six-month or annual basis, giving you the opportunity to take the money penalty-free at that time.
Step-Up CDs
Step-up CDs offer more flexible interest rates. Your rate will increase to keep pace when interest rates rise. This alternative can be attractive if your concern is being stuck with a paltry rate for the whole CD term. Again, these CDs pay less on average than traditional CDs.
Money Market Accounts
Money market accounts pay more than savings accounts, but generally not as much as CDs. The advantage is that you can do limited spending from a money market account using a debit card or a checkbook.
Credit Cards
Credit cards are an expensive way to borrow, but if you need money quickly and your CD will mature soon, it might cost less to put emergency expenses on a card and pay it off as soon as the CD matures. However, a much better idea is to keep a solid emergency fund. However, that’s just an illustration. Your bank may charge you interest on your withdrawal amount only or on the total balance of your account. The penalty may be calculated daily or monthly, and the interest may be simple or compound. The penalty usually depends on the length of the CD term. Contact your bank or consult your account disclosures to get the details for your particular account. A less-common reason you might think it’s worth it to accept an early withdrawal penalty is if interest rates go up significantly after you open your account. If you’ve found much higher interest rates elsewhere, you’d need to be sure that the interest you’ll earn will be high enough to compensate for the penalty of withdrawing from your current account.
