One aspect of CDs that can be costly for CD investors is the automatic renewal. Most banks and credit unions set up CDs so that they automatically renew when they mature. The new CD will typically have the same term as the matured CD. However, the interest rate may be much lower especially if the original CD was a special.
When a CD matures and automatically renews into a new CD, there is typically a grace period between 5 and 15 days when you can close the CD without an early withdrawal penalty. If you close the CD after this window of time, you will be hit with an early withdrawal penalty. Even if you miss the grace period by one day, the early withdrawal penalty can be as high as if you had tried to close the CD a year later.
A reader recently described in the forum how he was hit with a huge early withdrawal penalty when he was a little late closing his CD at Intervest National Bank. Unfortunately, Intervest's EWP is very harsh. According to the disclosure, for terms over 1 year it's the "amount of interest for 1/2 of the term of the certificate of deposit, earned or unearned." For a 5-year CD that's 2.5 years of interest. For many 5-year CDs the EWP is only 6 months of interest of less. Also note the last part of the sentence "earned or unearned". Even though the Intervest CD was just renewed, the penalty still included 2.5 years of interest. Thus, part of the principal was lost.
Automatic renewals are common at banks and credit unions. They will usually mail you a reminder a month or so before maturity, but those mailing can be easy to miss especially if you often take long trips. If you decide to open a CD, it's critical that you mark your calendars. I find Yahoo Calendar very useful. It can email you reminders, and the reminder can be for a date several years in the future.
Even if you think it's likely that you'll want to renew the CD, you don't want to forget. You never know if the new CD rate will be uncompetitive. So it's important to review the new CD rate. Also, it's important to check if there have been any changes in the account agreement. The renewed CD may have a larger early withdrawal penalty, shorter grace period or other changes. Most honorable institutions won't make these changes on existing CDs. However, when the CD matures, the renewed CD will take effect with these new terms. This happened last year at PenFed when it doubled its early withdrawal penalty on new 5-year CDs.
Not all banks and credit unions will force you to have a CD that automatically renews. PenFed is one example. In addition to the option of having the CD automatically renew, you have the option to have the funds transferred to your PenFed savings or checking account at maturity.
Also, not all banks and credit unions have early withdrawal penalties that includes unearned interest. For these cases, the penalty will not eat into your principal. PenFed is also an example of this. Here's what PenFed's disclosure states for CD terms of 5 years or greater:
If redeemed within 365 days of the issue date or any renewal date, all dividends will be forfeited.
If redeemed thereafter, but before the maturity date, dividends for the most recent 365 days will be forfeited.
If you had set up your PenFed CD so it automatically renews and if you had just missed the grace period, you won't be hit with a big penalty. You'll just lose the interest that accrued since the day it was renewed.
When you're opening a CD, it's a good idea to plan for maturity. Make sure you set up reminders so you don't miss the maturity date. Also, make sure you understand the bank's policies for CD closures. Make sure the bank or credit union makes it easy to close the CD during the grace period. As reader me1004 described, some institutions require advance notice to close a CD. Another reader also had a useful tip about knowing the methods allowed to withdraw the funds at maturity (i.e. check, ACH, wire). That can add costs and delays when you close your CD.
For more important issues, please refer to my post 10 Gotchas to Avoid for Bank CD Investors.