By sbup Staff
Certificates of deposit (CDs) earn higher interest rates than money market or savings accounts because they tie up your money for a specific amount of time.
Banks depend on deposits like CDs to fund their lending operations, which are the primary sources of their revenue. Consequently, banks make it difficult for customers to withdraw funds from CD accounts.
CDs typically carry severe penalties for early withdrawal. These penalties vary among banks but often consume a good portion of interest earned to date. Some banks even penalize the interest yet to accrue, which is taken out of your principal. When investing in standard CDs, you should be reasonably sure that you will not need to cash in early.
If interest rates rise, however, it can be tempting to cash in an underperforming CD early and reinvest in a CD at a higher rate. In this situation the new CD would have to offer an increased yield that outweighs the penalty for withdrawing early from the original CD.
For example, say you have a $10,000 one-year CD with an interest rate of 3%, which promises a yield of about $305. Three months into your CD term interest rates for one-year CDs rise by half of a percentage point. Should you cash out your current CD and invest in the CD at the higher rate?
The answer depends on the terms of the early withdrawal penalty. Three months’ interest is a common penalty on a one-year CD for cashing out early. For instance, Citibank (Stock Quote: C) charges 30 days of simple interest on any CD of 12 months or less, while Bank of America (Stock Quote: BAC) charges 90 days of interest on its 12-month CDs. The penalty from U.S. Bank (Stock Quote: USB) is the highest of the three and includes a $25 fee in addition to half of the interest you would have earned on the money you withdraw.
In the previously mentioned example, the BAC penalty would cost you about $75 if the CD compounded monthly. You could expect a yield of about $356 by reinvesting in a $10,000 one-year CD with an interest rate of 3.5%. Therefore, the increase in income by switching to the new CD would only be $51, $24 less than it would cost to cash out of the original CD.
Cashing in CDs early only makes sense when you can expect a higher yield in the new CD than it costs to get out of the old CD. In the previous example, a new CD with an interest rate of 4% would produce an expected yield of about $407 or an income increase of $102. Trading up to this new CD would make sense because you would make a net gain of $27 ($102-$75).
When considering cashing in an existing CD in order to reinvest in a CD at a higher rate, calculate your expected yield for both CD products. manybanking.com’s CD calculator calculates your ending balance based on the initial deposit, term and interest rate of your CD. You can also compare rates between local and national banks in manybanking.com’s CD Section. This tool can help you determine if there are better rate offers out there which would justify cashing out a CD early.