I was reading this month’s issue of Kiplinger magazine when I saw the article CD Penalties Are Not Created Equal.
Cashing out before the certificate matures can be costly. The article states that the average penalty for CDs of 1-year or less is 3 months of interest. The rate can be as high as 6-months on CDs of 1-4 year maturity. Some banks will even hit you for 20-25% of the total interest you would have earned for a 5-year CD.
I’ve long known that you forfeit a percentage of the interest if you cash out a CD before it matures, but there’s a key point I never knew. It’s in the last part of the paragraph above: “…the total interest you would have earned.”
Yes, that’s right – the penalty is a percentage of what you would have earned if you left the CD to maturity. This could lead the bank to take some of your principal if you haven’t earned enough interest to cover the penalty before you cash out the CD.
That sounds pretty bad, but I don’t think it is. Let me explain…
For the sake of example, let’s suppose you buy a 5-year CD worth $10,000. 1 Year later, you realize you need that money (maybe there is some medical bill or some other unexpected expense that you can cover with your emergency fund).
- If the CD was left until maturity, you would earn $1,611.84.
- By the time you redeem the certificate however, you’ve only earned $303.39.
- Using the above stated average penalty of 20% of the total ($1,611.84), your penalty would be $322.368.
But that would leave you with $9981.02 or a loss of only $18.81 (roughly 0.18%). And that’s if you redeemed it after only 12 months. You wouldn’t lose any principal if you held it for at least 2 years.
Even if the rate was 5%, you only be out about $55 after a year.
Don’t get me wrong, I never want to lose principal and I’m not comfortable throwing away money even if it’s less than 1%, but I wouldn’t lose sleep over it either.
Even if you bought a $100,000 5-year CD at 5% interest you’d only give up $600!
Bottom line – do the math, know the risk but don’t fret about the small stuff. I’ve wasted more money on a morning coffee through the years.
(all calculations were done using BankRate’s Certificate of Deposit Calculator.)
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