Since today’s CD rates are so compelling, a lot of people are rushing to open CDs before they start to fall. But there’s a big potential problem with putting money into a CD. If you need to take an early withdrawal, you risk a costly penalty for taking your money out before your CD matures.
The extent of that penalty will depend on your bank. But for a 12-month CD, it’s not uncommon to lose three months of interest for an early withdrawal. That’s not a risk you take in a savings account, so you may be inclined to just go that route rather than risk a penalty.
But with a savings account, your interest rate is not set in stone. And since interest rates are expected to decline somewhat soon, that may not be your smartest move. A no-penalty CD might seem like a better deal, since this way, you get to lock in a preset interest rate for a period.
As the name suggests, a no-penalty CD allows you to take an early withdrawal without a fee. But there are two big pitfalls you might encounter if you open a no-penalty CD.
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1. You’ll probably receive a lower interest rate
A big reason to open a CD in the first place is to score a higher interest rate than what a savings account will pay you. But because a no-penalty CD gives you more flexibility than a traditional one, you’ll generally be looking at a lower interest rate.
You’ll need to decide whether the protection of a no-penalty CD is worth the lower earnings. If you have a specific savings goal you’re trying to meet, a no-penalty CD may not be the best solution.
2. You may not be motivated to leave your money in the bank
One hidden benefit of CDs is that they motivate you to keep your money in the bank earning interest, because nobody wants to be penalized for taking out their own cash. With a savings account, it’s easy to dip in on a whim since there are no penalties to worry about.
But with a no-penalty CD, you basically lose that motivation. You may end up giving into temptation and withdrawing your money, thereby losing out on the interest income you were supposed to be receiving.
An alternative to a no-penalty CD
Because no-penalty CDs are a mixed bag, you may want to look at building a CD ladder instead. With a CD ladder, you divide your money into a few different sums and open a series of CDs with staggered maturity dates. For example, instead of taking $4,000 and putting it into a single no-penalty CD, you could instead put $1,000 each into a 3-month CD, 6-month CD, 9-month CD, and 12-month CD.
This way, you’ll have a portion of your money freeing up every three months. This gives you access to cash and might help you avoid an early withdrawal penalty, while potentially allowing you to lock in a better CD rate than a no-penalty CD will give you.
There’s no need to write off the idea of a no-penalty CD, and you may decide it’s a good solution for you. But make sure you understand the drawbacks before moving forward.
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