Bankers have noticed that interest rates are starting to rise, and they’re warning their colleagues that CDs with mild early withdrawal penalties can be costly for them. This was the message from an American Banker opinion piece, Banks Should Make It Harder to Withdraw CDs Early (Thanks to the reader who emailed me this article).
We have already seen many banks raise their early withdrawal penalties. I would expect to see more increases in the future. However, the article did not suggest bankers increase early withdrawal penalties on existing CDs. In fact it suggested that changes should only be made when CDs renew:
Existing CD customers should be sent a notice concerning the changes in the early withdrawal penalty that will become effective when their CD renews.
Fortunately, most institutions which have been raising their early withdrawal penalties haven’t raised penalties on existing CDs. There have been two important exceptions (see post).
In addition to providing this warning, the article described some history that I wasn’t aware of. According to the article, there used to be regulations that restricted early withdrawal penalties:
Many years ago the Federal Reserve eliminated the regulations regarding early withdrawal penalties on CDs. Today, banks can establish any structure for their early withdrawal penalty.
It also described what happened back in 1981 when interest rates skyrocketed:
On July 1, 1980, the average rate on a six-month CD was 8.73% and in July 1, 1981 it was 17.40% – over an 800 basis point increase in 12 months.
During this 12-month period, customers were coming to the bank and cashing CDs they had purchased only 30 to 60 days prior because it was cost effective to pay the early withdrawal penalty and reinvest at a higher interest rate.
I was only a child back then, but I remember my parents buying a 10-year 16% CD around this time. I don’t remember if they broke any CDs to fund this 10-year CD.
The article concluded by warning bankers that early CD closures should not be “cost effective” for CD customers. Some of the recommendations included raising the early withdrawal penalty to 12 months of interest for terms of 2 years and longer or to 50% of the term which would be 30 months of interest for a 5-year CD.
The article makes it clear that we should expect larger early withdrawal penalties. It’s important to not only review early withdrawal penalties when shopping for new CDs but also when you’re renewing a CD. When the CD renews, there may be a new penalty in addition to a new rate.