If you’re looking for a low-risk investment vehicle for your nest egg, then a bank certificate of deposit might be the sensible choice. CDs work just like a standard savings account, but you typically will earn more interest, and your investment is guaranteed by the Federal Deposit Insurance Corporation up to $250,000. The snag is that you may have to pay a penalty if you take your money out before the end of the CD term.
Safety Comes at a Cost
When you take out a CD, you promise to lock your money away for a fixed period such as 6 months or 2 years. At the end of the term, you get your money back with interest. Rates tend to be higher than the rate you’d get with a regular savings account to justify locking away your cash.
With most CDs, you can take your money out anytime you wish. But if you take your cash out before the end of the fixed period, then you’ll have to pay a penalty. The penalty might be a one-time fee, like $100 or, more likely, it will cost you a few months’ worth of interest. Banks generally charge anywhere between one month and a whole year’s worth of interest, depending on the length of your CD.
How Penalties Work
Determining the penalty is a harder calculation than you might expect because it depends on the exact formula used by your bank or credit union. Some banks calculate the penalty based on the amount you withdraw, while others assess it on the total balance of the account. Some banks calculate the penalty on a monthly interest basis, while others calculate it on a daily interest basis. There are many variables, so the most you can do is calculate a ballpark.
The first step is to check your bank’s policy on early withdrawals, which should be written in the terms and conditions.
A Couple of Examples
Suppose you have an 18-month CD with an interest rate of 1.00 percent. The early-withdrawal penalty is 6 months’ worth of interest, and the bank calculates the penalty based on the amount of money you withdraw. Let's say you have $20,000 in the account, and you want to withdraw $5,000. The formula would be:
Penalty = Amount withdrawn x (interest rate/12) x number of months’ interest
Penalty = $5,000 x (0.01/12) x 6 = $25
If your bank assesses the penalty based on the entire balance of the account, you’d swap that number into the formula like this:
Penalty = Account balance x (interest rate/12) x number of months’ interest
Penalty = $20,000 x (0.01/12) x 6 = $100
How to Avoid the Penalty
The money in an FDIC-backed certificate of deposit is so safe that no one has ever lost money with this type of investment – as long as the money stays in the account until maturity. While taking the money out early will certainly cut into the interest you’re earning, if you haven’t earned enough interest to cover the penalty, then most banks will take the penalty amount out of your original deposit. This means you’ll end up with less than you started with.
The surest way to avoid this scenario is to open a no-penalty CD that will not penalize you for accessing your cash before the CD matures. Rates tend to be lower with these types of accounts, and you may need a minimum deposit of $500 or more to open the account. But it might be worth it if you need somewhere to put your emergency savings and cannot risk being hit with a penalty every time you need to access your money.
- Federal Deposit Insurance Corporation: Understanding Deposit Insurance
- Business Insider: The Best CD Rates of September 2020
- Bankrate: Here’s When an Early Withdrawal From a CD Is Worth It
- Marcus by Goldman Sachs: No Penalty CDs
- Nasdaq: How to Calculate the Penalty on an Early Withdrawal of a CD
- Bankrate: The Pros and Cons of CD Investing
- Talk with your banker to see if they have a flat rate fee. Although this is much less common than percentage fees, some banks charge a set fee (such as $30 or $50) for the early withdrawal of a CD.
Jayne Thompson earned an LLB in Law and Business Administration from the University of Birmingham and an LLM in International Law from the University of East London. She practiced in various “big law” firms before launching a career as a commercial writer. Her work has appeared on numerous financial blogs including Wealth Soup and Synchrony. Find her at www.whiterosecopywriting.com.