Low Early Withdrawal Penalty On a CD Is Not Worth It
If you buy something expensive at a store, they usually offer an extended warranty. There is nothing wrong with extending the warranty itself. The only problem is that it’s usually very expensive. If I could get a five-year extended warranty on a $200 digital camera for $0.25, I would buy it, but not for $40.
When you buy a CD, the cost of recording is usually included in the price. If two comparable CDs offer the same refund, there is no doubt that you will prefer the CD with a lower subscription fee, regardless of whether you pay upfront or not.
What if the CD with a lower early withdrawal penalty also has a lower return?
If you choose the CD with the lowest initial cancellation fee, you are actually paying for it by accepting a smaller return, as if you were purchasing an extended warranty. How do I know if the price of the lowest cancellation fee is correct? Or are lower cancellation fees too expensive like most extended warranties?
I suspect it’s expensive just because behavioral economics says people tend to overestimate flexibility.
Ally Bank is popular in part because CDs previously imposed a 60-day fine. The penalty is now 90 days of interest for a period of three years or less, 150 days of interest for a period of five years. Forget for a moment that Ally Bank requires authorization before a pre-withdrawal is allowed; we assume you can cancel earlier whenever you want.
3-year CD Ally Bank with 90 days early withdrawal penalty pays 1.2%. CD PenFed 3 years with 180 days fine. Early withdrawal pays 2.0%. If you prefer Ally’s 3-year CD to PenFed’s 3-year CD, you will pay 0.8% of your projected interest income each year to reduce your early payment penalty by 0.7% (from 1% to 0.3%), only in case of early cancellation. This means that if you had not retired by the end of the first year, you would have paid a greater interest loss than in the past and benefited from a minimal early termination penalty.
5-year CD Ally Bank with a 150-day prepayment penalty pays 1.6% APY. PenFed CD for five years with a 1-year early withdrawal penalty pays 3.0%. If you choose Ally’s 5-Year CD over PenFed’s 5-Year CD, you will pay 1.4% of expected interest income to reduce your 2.34% prepayment penalty (% to 0.66 %). Pay to reduce during the match.
During the first year, an early withdrawal of more than 60% is required (1.4% / 2.34% = 60%). After two years of insurance, you will always be better off with PenFed CD because the higher income you earn in the first two years will cover the higher fine if you decide to cancel sooner.
If you buy a CD for five years, do you really expect a 60% chance of retiring after one year and a 100% chance of retiring early in the first two years? I do not do.
I think the small fine for early withdrawal of CDs was too high. Nice to have, but generally expensive, as is the extended warranty.
It is generally more profitable to sell options than to buy options. Over time, the price paid for a lower early termination fee increases (the lower return increases), while its value decreases. If interest rates increase over the four years of a five-year CD, the original maturity becomes a viable choice.