Are No-Penalty CDs Worth It?

Banks never stop innovating. For the most part that is good news for customers who have an ever increasing set of products and tools to use for their financial needs. The catch is that with so many permutations of money products and services out there, it can be confusing to know what is the right financial tool for you. Let’s do a no-penalty CD review to find out the pros and cons of a no-penalty CD.

What Is a No Penalty CD?

A no-penalty CD is like a normal CD, or Certificate of Deposit, except the bank will not charge you a penalty to withdraw your money after a certain date. It sounds like a no-brainer, but as always, the devil is in the details.

no-penalty cd savings graphic

What Is a CD?

Let’s start with what a normal CD is. That will make it easier to understand what a no-penalty CD is.

A normal CD, or Certificate of Deposit, is a savings product offered by banks, credit unions, and brokerages. Like a savings account, you deposit money with the bank, and in exchange they pay you interest on those funds.

However, unlike a savings account, you cannot withdraw your money at any time. In exchange for depositing your money with the bank and locking it up for a specified amount of time, the bank, or credit union will pay you a higher interest rate. For example, a bank might pay 0.5% on its normal savings account, but pay 1.0% on a 3-year CD.

That’s good right?

Let’s look at the cons of CDs before we decide.

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In a savings account, the bank will allow you to withdraw money whenever you want, up to the legal limit of six withdrawals per month. But, with the CD, you cannot make any withdrawals from the 3-year CD during the three year period. It’s not quite as draconian as it sounds. Generally speaking you can break the CD, but the bank will charge you a penalty. The penalty usually isn’t too terrible. Often the penalty for early withdrawal of a CD is to forfeit a certain amount of interest, such as forfeiting the most recent quarter of interest. They almost never take away any of your principal.

No-Penalty CD Features

No-Penalty CD Pros

The most important pro of a no-penalty CD is that there is no penalty for early withdrawal. That means you won’t lose any of your interest, or pay any other penalty if you choose to withdraw your money before the term of the CD is up.

No-Penalty CD Cons

A smart financial plan always looks at not just the benefits of financial tools, but also their drawbacks in order to achieve financial independence. In other words, always ask, “What’s the catch?”

In the case of a no-penalty CD there are two catches that may not be readily apparent. The first, is that when a bank, credit union, or brokerage offers both traditional CDs and no-penalty CDs, the difference between no-penalty CD and regular CD is that the no-penalty CD usually pays a lower interest rate than the regular CD.

The second catch to a no-penalty CD is that although you are permitted to make withdrawals from a no-penalty CD without penalty, you often must withdraw the entire balance, not a partial balance like you can with a savings account.

Are No-Penalty CDs Worth It? 1

See that? “…withdraw your full balance…”

In today’s current low interest rate environment the downside of withdrawing your whole balance may not be readily apparent. However, it is easy to imagine a scenario where you have $100,000 invested in a 3-year no penalty CD at 4.0%, and a year later, interest rates have fallen to where a 3-year CD is paying just 3.0%. Withdrawing the whole amount means breaking the CD and losing your higher interest rate.

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Be sure to watch for the usual bank tricks, like only paying the higher rate on part of your balance, or requiring that you have certain activities on your accounts like direct deposits, a minimum number of debit card transactions, or a minimum balance.

When Is a CD a Smart Investment?

Keep in mind that you should have an amount of liquid cash in your checking account sufficient to ensure that you never have a bounced check fee. In addition, you need a certain amount of cash as an emergency fund. After that, you can look into investing your dollars for long-term growth.

Can I Use a CD for My Emergency Fund?

A no-penalty CD or other CD is a good potential tool for your emergency fund. Since your emergency fund is not money you should be dipping into on a regular basis, locking it up in a CD is a good way to earn a higher interest rate than just leaving it in savings. With the no penalty feature, should you need your emergency fund due to job loss, or other financial crisis, you lose nothing.

CDs are like savings accounts and checking accounts and part of a bank’s FDIC insurance, or a credit union’s NCUA insurance.

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