Stashing money in a certificate of deposit is a good way to deploy a portion of your fixed income. But the interest, and even some principal, can be taken away if you cash the CD before it matures.
Early withdrawal penalties can be stiff. One bank charges 365 days' simple interest for the early withdrawal of CDs with terms of 36 months or longer. Federal law stipulates that all CDs that are cashed out early are subject to a minimum penalty of at least seven days' simple interest on amounts withdrawn within the first six days after deposit. Other than that, banks are free to set their own penalties. There is no maximum limit on penalties.
It's not unusual to see the following penalties:
What's worse than forfeiting interest you've earned? Forfeiting interest you haven't earned.
Suppose you bought an 18-month CD and decided to cash out after four months. You would have to pay six months' interest even though you had earned only four. That means you're digging into the principal you paid for the CD.
Some banks may impose a stiffer penalty the earlier a withdrawal is made in the term.
The moral is, before you buy the CD, be sure you have enough money to cover any emergencies so you don't need to raid the CD account.
In some instances, early withdrawal penalties can be waived. Penalties may be waived if the CD owner dies or is declared mentally incompetent. Most institutions will also waive penalties for an IRA or 401(k) for anyone over age 59½.
Early withdrawal penalties are deductible if you itemize on your tax return.
There is a way to invest in CDs and possibly not pay a penalty for early withdrawal.
Brokered CDs -- CDs bought through a deposit broker -- are sometimes advertised as not having a penalty for early withdrawal. It's true that no penalty is levied, but what you're doing is selling that CD on a secondary market and accepting what you get for it. You could get less than you paid originally.
If you have a three-year CD at 5 percent interest and you want to sell at a time when the highest rate on a three-year CD is 4 percent, you'll get a premium for your CD. But if you're strapped for cash and have to sell when the current best rate on a three-year is 6 percent, you'll probably have to sell at a discount because your CD doesn't pay as much as the current CDs.
Typically, you'll get a higher rate with a brokered CD because brokers get CDs from banks across the country.