When you establish a certificate of deposit (CD), you agree to lend money to a financial institution. However, the financial institution has the right to assess a penalty fee if you close your account before the end of the CD term. Penalty fees vary and can cut into your principal as well as interest, although some banks offer penalty free CDs.
Banks use the money that you deposit into your CD to fund loans. A bank could become insolvent if it wrote large numbers of loans against CD money, and the CD holders to cash in their CDs before the end of the loan terms. Penalty fees on CD terminations reduce the likelihood of account holders redeeming their CDs prior to maturity, but also provide the CD issuer with some financial recompense in the event of a premature withdrawal.
When you cash in a CD prior to the end of the contract term, you have to pay a penalty of at least seven days of interest as mandated by federal law. However, while federal laws address the minimum penalty fee, no rules exist that cap the maximum fee that a bank can charge. Banks usually charge a penalty fee of seven days interest on CDs that have a term of 30 days or less. The penalty fees on longer term CDs usually amount to at least a three months of interest. Typically, the longer the CD term, the larger the interest penalty. Some banks assess a principal penalty fee alongside or instead of an interest penalty fee. Others even charge a flat administrative fee for account closures.
Some banks sell hybrid products known as no-risk or penalty-free CDs. These accounts are similar to regular CDs in that you usually earn a fixed rate of interest for a specific period of time. However, you have the ability to make a total or partial withdrawal without incurring a penalty. No-risk CD offerings vary from bank to bank, and at some banks you can access your money at any time, while other banks provide you with occasional windows of opportunity during which you can make withdrawals.
Index Linked CDs
Many banks market CDs as securities, and you can purchase these accounts through an investment broker. Some brokerage CDs pay a regular interest rate but others pay you a return based upon a market index, such as the S&P 500. Generally, you incur a penalty if you redeem a brokerage CD early although some banks give you the option of making annual penalty free withdrawals on multiyear CDs. If you cannot redeem a brokerage CD without penalty, you may have the option of selling the CD to another investor as some brokerage CDs are marketable. However, when you sell a brokerage CD, you have to agree on a sale price with the buyer, which means you can sell the CD at a premium, but you may have to sell the account at a discount.