With CD rates at record lows, certificates of deposit aren't much more than a lockbox to keep buyers' money safe until better opportunities present themselves. However, should you need to open that lockbox early, expect to pay a hefty CD early withdrawal penalty for the privilege.
Many consumers may think of their CD principal as sacrosanct, but should they cash in early, 97 percent of the institutions Bankrate surveyed in February would dig into principal to satisfy a CD early withdrawal penalty if the interest accumulated at that point won't cover it. That's up from 92 percent in our 2010 survey and introduces a risk that many CD investors may not be aware of, says Greg McBride, CFA, senior financial analyst for Bankrate.com.
"The whole reason people invest in CDs is to preserve the value of their principal, but getting your timetable wrong is potentially going to cost them principal," he says.
Fortunately for holders, CD early withdrawal penalties haven't risen on average since our last survey. As in 2010, the most common penalty is still three months' interest for CDs with maturities of less than one year, and six months' interest for CDs with maturities of one year and longer.
Still, penalties varied widely. For closing a one-year CD early, some institutions, including Bank of the West and Boeing Employees Credit Union, charged a penalty of only 30 days' interest.
On the other end of the scale, some institutions, such as Bank of America and JPMorgan Chase & Co., charged as much as $25 in cash plus 3 percent of principal.
Under the above two pricing schemes, if a consumer closes an entire $10,000 one-year CD, it amounts to a difference in penalty of $1.60 versus $325. That difference in penalty underscores the need for consumers to take a close look at the fine print for CDs before committing their money, McBride says.
Why the stiff penalties?
"Banks use CD balances to fund loans, and they don't want consumers taking their money out should interest rates rise. So, they need penalties to be a big enough stick to keep people from leaving en masse and causing them funding problems," McBride says.
One bright spot in our survey: If you accidentally let a CD automatically roll over, the Bankrate survey found banks typically allow a grace period of seven to 10 days for savers to withdraw the money without penalty.
CD early withdrawal penalties undermine appeal
Historically, savers have been willing to put up with CD early withdrawal penalties because CDs generally yield better returns, says Kent Grealish, a partner in Quacera Capital Management LLC in San Bruno, Calif.
"For no-risk money, (investors) can give up a small amount of availability or liquidity in exchange for a modestly higher return over alternatives, which would be savings accounts or (Treasury) bills," he says.
But with CD rates at all-time lows, that dynamic is starting to change, says Dan Geller, executive vice president at Market Rates Insight in San Anselmo, Calif.
"As CD rates started dropping, the marginal difference in the APY (average percentage yield) between CDs and other liquid accounts such as savings or money markets shrank," he says. "It's reached a point that for some consumers, the marginal difference was not enough to justify locking the money up for a certain term."
McBride agrees. "There's not enough of a yield premium on longer-term CDs to justify taking the risk of that early withdrawal penalty," he says.
Savers seem to be catching on to this predicament. Since Bankrate published its last survey in February 2010, the amount of money in CDs nationwide has declined by 35 percent, according to the Federal Reserve. In that same period of time, savings account deposits have risen by 26 percent.
CDs still play a role
Despite low yields and increasing CD early withdrawal penalties, CDs still have a role to play for investors, McBride says.
"CDs are conducive to a few things: generating a predictable stream of interest income for retirees, but also aligning your cash availability with specific expenses at points in the future," he says. "If you know you have tuition payments that you have to make at a certain time every year, you can invest in CDs that will mature around that point in time."
Sometimes the threat of a CD early withdrawal penalty can actually help investors by enforcing a little fiscal discipline, Grealish says.
"There's a behavioral value because these funds are at least somewhat committed to the maturity date, so investors have a way of mentally segregating those in their mind," he says. "It makes it less likely that the assets will be used for consumption or spur-of-the-moment investing as a savings account or a money fund might."
Even so, there is little overall incentive to accept the lack of liquidity inherent in CDs if there is any chance you might need to withdraw the money before the term is over, McBride says.
"You have to develop a realistic assessment of your timetable," he says. "How long can you afford to live without the money, and do you have a sufficient emergency savings cushion or other access to cash so that you don't need to liquidate a CD prior to maturity?
"A lot of people just aren't in a position to invest in CDs regardless of returns because they don't have sufficient cash reserves," McBride says. "Only 24 percent of American households have an adequate emergency savings cushion."
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