CD penalty often worth the cost

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Dear Dr. Don,
I’ve looked at the early withdrawal terms for several banks’ CDs and compared the yields of their various terms to one another. Something doesn’t seem to be adding up for me.

In many cases, it seems the penalty is insufficient to dissuade the longer investment. Cashing out the longer-term CDs at the same date as a shorter one nets greater interest, even after the penalty is applied.

Are there hidden penalties to cashing out a CD before its maturity date, perhaps something to do with credit score?
— Edward Early

Dear Edward,
What you’re talking about is called “riding the yield curve,” and it’s more commonly done by bond investors than CD investors.

A yield curve shows how yields for a specific risk class of fixed-income investments vary over time. A normal yield curve is upward sloping, meaning longer-term investments have a higher yield than more liquid, short-term investments.

Investing in a five-year CD when you need the money in two years may result in a higher yield than investing in a two-year CD even though you have to pay an early withdrawal penalty.

Banks are all over the map when it comes to the substantial penalty for early withdrawal. The reason for the penalty is straightforward enough. The bank is paying a higher interest rate to have your deposit committed for a period of time. Savers who break that agreement by cashing out early can leave the bank scrambling for funds to replace the deposit.

Does it make sense to pay the penalty and reinvest at higher CD rates? As you point out, it depends on the amount of the penalty and how big a yield pickup you receive on the new deposit. You can consider the penalty the price of an option to reinvest at a higher rate.

You’d rather lock when rates are high. But if you’re “long and wrong,” paying the penalty lets you reinvest the deposit. Bankrate’s “2010 CD early withdrawal penalty study” takes a look at the penalties in different markets for different maturities.

Withdrawing the deposit should have no impact on your credit score. What can have an impact is if the next financial institution you invest with does a “hard pull” on your credit report, creating an inquiry on that report.

You wouldn’t expect it because you’re not applying for credit, but it does happen at some financial institutions. Inquiries stay on your credit report for two years but only influence your credit score in the first year.

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