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  Dear
Dr. Don,
With interest rates on CDs beginning to rise,
at what point would it make sense to cash in a low-rate CD, pay
the penalty and reinvest at the higher rate?
-- Jackson Action
 Dear
Jackson,
You've got to be able to recoup the early withdrawal penalty by the
additional interest earned over the remaining term of the existing
certificate of deposit for it to make sense to get out of the existing
deposit agreement. The early withdrawal penalty may, however, be deductible
on your taxes, reducing the effective hit on your return. The financial
institution sets the early withdrawal penalty, but it's not unusual
to see the following penalties:
| CD term |
Interest penalty |
|
30 days
|
All interest
|
|
Two to 18 months
|
Three months
|
|
Two years or more
|
Six months
|
Some institutions levy even stiffer penalties.
If you are currently earning 3 percent on a $10,000,
five-year CD with two years remaining until maturity, and the early-withdrawal
penalty is six months' interest, you'll pay a penalty of $10,000
x .03 x 6/12 = $150.
If you can invest the proceeds in a new CD earning
5 percent for five years, then you'll pick up an additional 2 percent
over the remaining two years, which is $10,000 x .02 x 2 = $400.
Switching CDs makes sense because you pay a $150 penalty, but pick
up an additional $400 in interest earnings, putting you $250 ahead.
|
Initial
deposit
|
$10,000
|
| Deposit earns (compounded monthly): |
3%
|
| Initial term (months): |
60
|
| Remaining term (months): |
24
|
| Interest penalty (months): |
6
|
| Penalty amount |
$150
|
| New rate: |
5%
|
| Interest earned over remaining term: |
$400
|
This approach is somewhat simplistic, but it gets
the idea across. You've got to be able to make up the early-withdrawal
penalty with the increased interest income over the remaining term
of the original CD.
The downside in this example is that you extend
your investment horizon out another three years when you buy the
new five-year CD and, if rates keep going higher, you'll want to
get out of that CD eventually. Extending your investment horizon
can make sense, but stringing together a collection of CD investments
where you continue to be "long and wrong" isn't a great
approach to investing. Laddering a CD portfolio can be a better
approach over time. Bankrate's "CD
ladder evens out rate cycles" can show you how to ladder
your CDs.
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