Don’t Avoid CDs Because You Fear Early Withdrawal Penalties

When researching savings options, conventional wisdom says that you shouldn’t get a certificate of deposit (CD) if you think you might need to access the cash before the term is over. That’s because with most CDs, you’ll incur an early withdrawal penalty. However, there are some cases in which an early withdrawal penalty shouldn’t be a deterrent.

Learn more about how CD early withdrawal penalties work, and how to decide if and when they may be worth overlooking.

What Is a CD Early Withdrawal Penalty? 

The agreement you make when you open a CD is that a financial institution pays you fixed interest on your principal at the end of a predetermined term, and in exchange, you won’t touch the funds until the maturity date. An early withdrawal penalty is what you’ll pay if you break that agreement and take your money before the end of the term.

The most typical structure for a CD early withdrawal penalty policy is that a number of months of interest will be forfeited. Usually, it’s based on the length of the CD. 

Some penalties are relatively mild, while the worst ones are so unfavorable they should be avoided entirely. 

Factors That Affect the Penalty for Early CD Withdrawal 

Though many CDs have similar rules for early CD withdrawal penalties, slight differences could affect how much money you walk away with. Some of the determining factors include:

• The bank or credit union: Each bank has discretion to set its own CD terms and conditions, including for early withdrawal penalties. Some banks and credit unions are more lenient than others. 
• The length of the CD: Penalty amounts vary depending on the CD term. Usually, longer-term CDs (more than a year) will have you forfeit more months of interest than a shorter-term CD (less than a year).
• The yield: Higher yields will end up having steeper penalties because the formula for many CDs is to subtract a set number of months of interest. Therefore, it’s worth doing some number-crunching to see what you’d walk away with if you were to access your money early. 

What's a Typical Early Withdrawal Penalty? 

The most typical structure for an early withdrawal penalty is that you’ll forfeit a set number of months of interest, depending on the length of the CD. For instance, a common penalty on a one-year CD is three months of interest. In other words, if you cash out after just six months, you’ll be paid three months of interest instead of six (having forfeited three months’ worth). But a two-year CD from the same bank may carry a penalty of six months’ interest. 

Other Types of Early Withdrawal Penalties

In addition to losing a set number of months of interest, some CDs use different calculations or methods to determine an early withdrawal penalty. 

• A percentage of the balance: You may find that some banks impose a set percentage, such as 1% of your balance, rather than a number of months of interest.
• A flat fee: Some banks have a minimum penalty amount (e.g., $25) if you withdraw early. 
• An interest amount even if the interest hasn’t yet been earned: This type of condition isn’t favorable to you because it has the potential for you to end up with less money than you started with. For example, a CD might have a penalty of six months of interest even if you’ve only had it open for two months.

When Is It Worth It to Make an Early Withdrawal on a CD? 

Making an early withdrawal on a CD shouldn’t be something you plan on doing, but you should at least understand the costs if a situation arises that warrants pulling your money out. Some scenarios where it might make sense to do that include:

• To cover an emergency expense: If an unexpected cost arises because something breaks down or because of an accident or injury, withdrawing from a CD early is one of the least costly ways to come up with the funds you need. Sure, you may lose out on some earnings you might have acquired, but unlike a credit card or personal loan, you won’t have to pay interest and you won’t owe anyone repayment.
• To make a down payment: If you decide to make a purchase and a larger upfront payment can help you score a better interest rate or more favorable terms, tapping into CD savings—even if you incur an early withdrawal fee—can save you money in the long run.
• When rates are rising and much better yields become available: If you’re tied up in a longer-term CD and then rates begin to shoot up, you may come out ahead by removing the funds and reinvesting them in a CD with a higher yield.

Are No-Penalty CDs a Good Idea? 

You might be intrigued by the concept of no-penalty CDs because they seem to have no downside. While it’s true that you do get to avoid early withdrawal fees, these products usually have a lower yield than regular CDs. The interest you’d be losing by missing out on a better rate is likely worse than the potential penalty you may end up avoiding anyway.

How to Minimize Penalties on CD Withdrawals 

If you’re new to savings strategies like CDs and want to do your best to avoid penalties for dipping in early, here are a few pointers to keep in mind,

• Find out where interest rates are headed. If the Federal Reserve is expected to increase the federal funds rate over the next year or so, that means CD rates will go up as well. So, it may not be a good time to lock in a rate with a longer-term CD because you could miss out on a better rate later. On the other hand, if rates are predicted to fall, you do want to grab a CD that will let you earn a higher rate now and for a long time into the future.
• Build at least part of your emergency fund first. You don’t want to tie up every penny of your savings for an extended period of time in a CD. Keeping some of your savings liquid is wise.
• Choose a shorter term. It’s a lot easier to avoid an early withdrawal penalty on a three-month CD than a five-year one. Luckily, many banks and credit unions offer promotional CDs through which you can find some short-term options with strong yields.
• Build a CD ladder. Instead of investing your full amount, with a CD ladder strategy, you divide your deposit equally among a few CDs with different terms. That way, at least part of your money will become available every few months.
• Buy multiple smaller CDs with similar terms. If you don’t want to build a CD ladder, you could alternatively break up the money you have to invest into, say, quarters, and invest each quarter in separate CDs. That way, if you need some funds, you may only need to break one or two CDs to get the money you need and you could keep the rest of the CDs intact. You could even stagger the timing of your CD purchases if you’re unsure where interest rates are headed.

How to Choose a Good CD 

1. Look for a strong interest rate. Banks and credit unions are competing for your business, so search for the best CD rates when deciding where to put your money. That way, even if you do end up paying a penalty, you’ll still come away with some good earnings.
2. Do your homework on the early withdrawal penalty. Before you commit to a CD, look over all the terms and conditions, but especially the penalty for early withdrawal. 
3. Select the best term for your needs. Think about your savings goal and when you might need access to the money and try to match up with a CD timeline that works for you. It’s better to go shorter rather than longer to avoid a potential penalty. 

The Bottom Line

Although the best course of action is to try and avoid CD early withdrawal penalties by leaving your money in for the full term, you should understand the terms and have a game plan in case you can’t. Overall, your best protection against early withdrawal penalties is not opening a CD with money that you know you’ll need access to. But in some circumstances, such as if CD rates increase significantly, the risk of losing a few months' worth of interest may still be worth the penalty.