If you use them for the right reasons, CDs are a great way to earn higher rates of interest at a lower risk. However, if you have a CD and need to withdraw it, you might want to think again. Taking an early CD withdrawal can eat into the interest you have earned. Here are several things you need to consider before making a withdrawal from your CD and general information about how they work.
How CDs work
Certificates of deposit (CDs) are issued by a bank for a set amount, say $5,000, and pay interest on a regular basis until the maturity date of the CD (which typically ranges from 6-months – 5 years). Though most CDs carry very basic terms, there are also a variety of special options available at some banks and credit unions. Some examples include variable interest rates or even penalty-free withdrawals. That said, you shouldn’t open a CD unless you plan to hold the money for the full length of term, and you should always understand the withdrawal conditions, just in case the need arises.
The first thing to know is that, like all types of savings accounts, the earlier you withdraw from your CD, the less interest you will earn. Secondly, withdrawing earlier than the maturity date will usually involve paying some sort of penalty fee. This penalty may be a flat fee, a specified number of months worth of interest, or some combination of the two. Say you have a 2-year CD and you cash it after 7 months. You might have to forfeit 6 months of interest for early withdrawal, leaving you with very little in the way of yield. You won’t usually be able to avoid this fee even if you only need to withdraw a small amount, since most banks stipulate that no partial withdrawals are allowed. In some extreme cases, however, there may be exceptions to the rule. According to Community Savings, a bank in Florida, its penalty fees may be waived “if someone dies or is declared mentally incompetent.”
When are CDs appropriate?
Experts recommend that everyone have an emergency savings of 3-9 months worth of expenses in the event of a job loss. This money should be stashed in a liquid account (such as a basic savings account) and should be the first priority before considering a CD investment.
Understanding exactly what you are saving money toward is important when shopping for any financial product. CDs may be a better option if when you have a longer-term goal such as saving a down payment toward a home, spending money for a family vacation or capital to fund a new business. Knowing when you will actually need the money is crucial when choosing the length of the CD term. Long-term CDs will earn higher rates but offer less liquidity than a 6 month CD, and vice versa. Potential investors should also understand that CDs are usually not the best for those with a longer time horizon and the ability to take on more risk, such as a young adult saving for retirement. Thanks to FDIC insurance, they are more secure than investments such as mutual funds, but they will also earn much lower yields in the long run.
If you’ve already built up a cash reserve for emergencies and still have a bit more money to invest toward small-term saving goals, you’ll want to consider laddering your CDs. Laddering CDs can provide a little time cushion between maturity dates and prevent a single investment to be locked in just one rate of return, especially if the interest rates are on the upward climb.
The best advice on CDs is to understand how they work, use them for what they were designed for and as the old saying goes – don’t put all your eggs in one basket!
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