By Ari I. Weinberg
Question: I have excess cash that is currently earning 1%. I can triple that by committing money to a 10-year certificate of deposit. I also know that interest rates can only go up from here and locking in money for 10 years is probably not a good idea. Can’t I put money in the CD and then pay the early withdrawal penalty if and when other investments look more attractive? This looks like an easy way to get a decent return on idle cash without much risk. Am I missing something?
– Jack Fesner
Answer: Investors seeking a return on cash are looking everywhere these days — even 10-year CDs earning 2.5% per year. While that looks promising compared to the negligible interest on savings accounts, you’ve already hit on a key reason not to take the longer rate. “It’s not good to make a long-term commitment if you can’t get out without penalty,” says Dan Geller, executive vice president at financial consultant Market Rates Insight.
Many banks have caught on, and adjusted their early withdrawal penalties to discourage exactly the behavior you’re talking about. For example, American Express Savings Bank assesses a penalty which is the greater of six months interest or a calculation called “cost recovery value.” The cost recovery value calculation occurs if the interest rate on a CD matching your remaining term is higher than the rate you’re paying. For example, if you withdraw your money from a 5-year CD after three years, American Express will check if its 2-year CD has a higher rate; if it does, it will apply the rate differential when assessing your penalty.
For banks that only charge simple interest on early withdrawals, you may be willing to take the penalty. At Discover Bank, the early withdrawal fee for a 5-year CD is 6 months simple interest on the amount withdrawn. For less computational hassles, you might also consider a CD that allows you to make no-penalty withdrawals, or one that protects against inflation by adjusting the interest rate to loosely track the consumer price index. Other banks offer so-called bump-up CDs which allow a one-time increase in the interest rate for the remainder of the term.
In general, we hate to tell folks to “read the fine print.” But this is one situation where there’s a cost to being wrong — and if you’re looking to take advantage of the rules, it’s worth squinting to know what they are.