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 used to impose a low 60-day early withdrawal penalty. Now the penalty is 90 days of interest for terms 3 years or under, 150 days of interest for 5-year term. For the moment, forget that Ally Bank requires consent before allowing an early withdrawal; assume you can withdraw early whenever you want.
[The rates mentioned below are as of Jan. 4, 2014.]
Ally Bank’s 3-year CD with 90-day early withdrawal penalty pays 1.2%. PenFed’s 3-year CD with 180-day early withdrawal penalty pays 2.0%. If you favor Ally’s 3-year CD over PenFed’s 3-year CD, you effectively pay 0.8% from your expected interest income each year to lower your early withdrawal penalty by 0.7% (from 1% to 0.3%) just in case you withdraw early. This means if you don’t withdraw by the end of year one, you already paid more in lost interest than you will ever benefit from low early withdrawal penalty.
Ally Bank’s 5-year CD with 150-day early withdrawal penalty pays 1.6% APY. PenFed’s 5-year CD with 1-year early withdrawal penalty pays 3.0%. If you favor Ally’s 5-year CD over PenFed’s 5-year CD, you effectively pay 1.4% from your expected interest income each year to lower your early withdrawal penalty by 2.34% (from 3% to 0.66%) just in case you withdraw early.
During the first year, you need a better than 60% odds to withdraw early (1.4% / 2.34% = 60%). After holding two years, you are always better off with the PenFed CD because the higher yield earned during the first two years already covered the higher penalty if you choose to withdraw early.
If you buy a 5-year CD, do you realistically expect to have a 60% chance to withdraw after one year and 100% 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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