CDs are often recommended as good short term investments by financial planners. If you need to keep money aside for emergencies or an upcoming expense, CDs are an alternative to savings accounts or money market funds. Their yields, depending on the length of the CD, can be better than bank accounts. However, unlike bank accounts, most CDs come with a penalty for early withdrawal. And the penalty generally increases with the length of the term.
Bankrate.com conducted a survey of early withdrawal penalties at 100 banks in the top ten markets. They found that CDs with maturities less than 1 year generally had a penalty of 3 months interest. 12 month or longer CDs usually charge 6 months interest. But 5-year CDs had penalties as high as 20 to 25 percent. What might not be as clear is that “interest” means the total interest you would earn if you held the CD to maturity. Therefore if you withdraw your money before you’ve earned enough interest to cover the penalty, the bank will take some of the principal.
To avoid penalties, consider the purpose of your savings. If you are setting aside money you anticipate using for a particular purpose in the future, such as a down payment on a house, a tax bill or a new car, tailor the CD to that event. Buy a CD that will mature at the point that you need the money. If you have no definite purpose, then consider laddering your CDs – for instance buying several CDs that mature at 6 month or 12 month intervals. Laddered CDs are also a good idea in the current low-interest rate environment, so that you have more opportunity to roll over to a higher rate CD should interest rates begin to rise.
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