One of the reasons certificates of deposits, or CDs, are popular in today’s market is because they are safe investment tools. They are relatively safe for two main reasons: They promise a return on principal and they are covered by FDIC insurance. You don’t get all of that safety for nothing, however. You pay for it in lower interest rates than riskier investments and restricted access to your money during the CDs term.
Right now, interest rates are virtually at rock bottom. But what happens when they rise? If you are holding onto a CD with an interest rate significantly below the going rate, you are effectively losing money. The problem is, you can’t just take your money out of a low-rate CD and reinvest it in a higher-rate CD. Why? Because of early withdrawal penalties.
If banks just let investors take money freely out of CDs, they would have no reason to offer rates above typical money market and savings account interest rates. Banks can afford to offer higher rates on CDs because the long-term commitment of the investor allows them to in turn make long-term commitments on other investments. The penalties they impose for early withdrawal are designed as disincentives to make sure your money stays with the bank as long as it should.
Early withdrawal penalties for CDs usually come in the form of losing interest. Depending on the conditions of your CD, you might have to pay 30 to 90 days worth of interest if you take money out of a 12-month or less CD early. Longer term CDs typically may have even stiffer penalties. If you haven’t earned enough interest yet, the penalty could erode some of your principal.
In order to decide whether or not it makes any sense to cash out early, you have to crunch the numbers and factor in the penalty. If you stand to make more invested in a new CD (less the penalty) than you will with the old CD, then you should do it.