Low Early Withdrawal Penalty On a CD Is Not Worth It

By Harry Sit

Yellow card

When you buy something expensive at a store, the store often offers to sell you an extended warranty. There’s nothing wrong with the extended warranty itself. The only problem is that it’s usually way overpriced. If I can get a 5-year extended warranty on a $200 digital camera for $0.25, I would buy it, but I would not buy it for $40.

When you buy a CD, the early withdrawal penalty often comes up as part of the consideration. If two similar CDs offer the same yield, there’s no question you would favor the one with a lower early withdrawal penalty, whether you actually withdraw early or not.

What if the CD with a lower early withdrawal penalty also comes at a lower yield?

If you pick the CD with a lower early withdrawal penalty, you are in effect paying for it by accepting a lower yield, in the same way you buy an extended warranty. How do you know whether the price for the lower early withdrawal penalty is fair? Or is the lower early withdrawal penalty overpriced as most extended warranties are?

I suspect it’s overpriced most of the time, only because behavior economics says people tend to way overvalue flexibility.

Ally Bank is popular partly because its CDs impose a low 60-day early withdrawal penalty. For the moment, forget that Ally Bank requires consent before allowing an early withdrawal; assume you can withdraw early whenever you want.

Ally Bank’s 5-year CD with 60-day early withdrawal penalty pays 1.64%. CIT Bank‘s 5-year CD with 1-year early withdrawal penalty pays 1.80%. If you favor Ally’s 5-year CD over CIT’s 5-year CD, you effectively pay 0.16% from your expected interest income each year to lower your early withdrawal penalty by 1.53% (from 1.80% to 0.27%) just in case you withdraw early.

During the first year, you need a better than 10% odds to withdraw early (0.16% / 1.53% = 10%). The second year 21% odds (0.16% * 2 / 1.53% = 21%). The third year 31% odds, the fourth year 42%, the fifth year 52%.

A local bank near me offers 5-year CDs at 2% yield with a 6-month early withdrawal penalty. Doing the same calculation, in order to favor Ally’s 5-year CD at 1.64%, I need the odds for early withdrawal at 49% after 1 year and 99% after two years. After holding two years, I’m always better off with the 2% CD because the higher yield earned during the first two years already covered the higher penalty if I choose to withdraw early.

If I buy a 5-year CD, do I realistically expect to have a 99% chance to withdraw early during the first two years? I don’t.

I think low early withdrawal penalty on a CD is overrated. It’s nice to have but it’s often overpriced, just like an extended warranty.

As a general rule, it’s more profitable to sell options than to buy options. As time moves on, the price paid for a lower early withdrawal penalty increases (lower yield multiplies) while its value decreases. If interest rates go higher in year 4 of a 5-year CD, finishing the original term becomes a viable choice.

[Photo credit: Flickr user Anders V]

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Posted on November 12, 2012 under Banking and Credit Cards. Keywords: .

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One Comment on Low Early Withdrawal Penalty On a CD Is Not Worth It

  1. Michael on November 12, 2012
     

    I agree — and I also think that the extended warranty is an apt comparison. You definitely need to do the math before trading APY for flexibility. The same goes for “raise your rate” products.

    That being said… We snagged a boatload of 5 yr Ally CDs back when they were offering the best available rates. When combined with the 60 day penalty, we got the best of both worlds.

    I broke them into multiple CDs to make it easier to access the money in chunks. I was looking for a (relatively) short-term place to park the money but better rates than would otherwise be available.

    Yes, the new “consent” clause makes me a little nervous, but so far so good. And if they refused to let us redeem it wouldn’t be the end of the world.

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