Note: This article is part of our Basic Banking series, designed to provide new savers with the key skills to save smarter.
Certificates of deposit (CD) often pay higher interest rates than regular savings accounts. However, your money is locked up for the term of the CD. Withdrawing money from a CD before it matures typically incurs an early withdrawal penalty.
CD loans offer one way for consumers to unlock the money they have in a certificate of deposit. With a CD loan, you borrow money by using the funds in a CD as security. This can be a good way to access liquidity without incurring early withdrawal penalties, although CD loans are not without costs of their own, in the form of interest and fees.
Let’s take a closer look at how CD loans work, and decide when they might be worth your while.
What is a CD loan and how does it work?
A CD loan is an installment loan that uses your CD as collateral. This often results in easier approval and lower interest rates than other types of loans because you're borrowing money against the money you've deposited in a CD, which lowers the risk for the lender.
Loan amounts vary by lender. Some CD loans allow you to borrow up to 100% of the amount held in your CD. You'll then repay the loan amount plus interest in the form of fixed monthly payments spread out over your loan term. Typically, you'll have until the end of your CD term to pay back your loan. Some CD loans also come with an origination fee, which increases the cost of the loan.
Not all banks offer CD loans. If you're able to apply for a CD loan through the same bank that holds your CD, the application process will likely move more quickly. In general, approval can be faster with CD loans than with unsecured loans, with some banks offering conditional approval within hours of application.
Pros and cons of CD loans
According to Brent Weiss, co-founder of Facet Wealth, CD loans can be a creative way to access cash quickly when there are no other liquid assets available. Weiss warns that it's important to consider the pros and cons before jumping into one.
Pros of CD loans
- Easier approval
- Lower interest rates
- Builds credit
- Keeps savings in place
- CDs continue to accrue interest
Weiss explains that the underwriting process is streamlined if you already have a CD with the bank, so the approval process is much simpler than it would be for an unsecured loan. You'll probably be able to secure a lower interest rate as well.
Another perk is that you might see a boost in your credit score over time. As long as the lender reports your payments to the credit bureaus, secured loans can be an effective way to build credit. In the meantime, your CD will continue to earn interest, which can be cashed out when it matures as long as you repay your loan on time. It's worth noting that you won't be able to access the funds in your CD until you've paid off your CD loan in its entirety.
Cons of CD loans
- Interest charges
- Possible origination and prepayment fees
- Not offered by all banks
- Less flexible loan terms and amounts
- You risk losing your CD
CD loans might come with lower interest rates, but you're still paying interest fees to borrow money that you already have in a CD. In addition, some CD loans may charge origination fees or prepayment fees if you decide to pay off the loan ahead of schedule. You also won't be able to borrow more than the amount you've deposited into your CD, and if your CD term is almost over, you'll face large monthly payments.
When shopping for a CD loan, you must compare the total term interest charges and fees of a loan to the withdrawal penalty you would pay to take money from your CD. An early withdrawal penalty might cost you less than the interest on a CD loan, after all.
Should you get a CD loan?
Weiss admits that he doesn't see many situations in which a CD loan would be the best choice. "You're turning a liquid and risk-free asset into a more aggressive loan vehicle," he explains. You're also putting both your CD and your credit score at risk.
Instead, Weiss encourages consumers to pay in cash and then "repay themselves" by depositing money into a savings account each month. This method will help you avoid fees while ensuring that you still have cash to cover future expenses.
If you already have a CD and need short-term fast cash, Daniel R. Hill, president of D.R. Hill Wealth Strategies, says that a CD loan is an option worth considering. Not only does it come with lower interest rates and fewer qualification requirements than most loans, but you can expect to receive the funds you need "almost instantly." Consumers with little to no credit history are also good candidates, he explains, because approval is easier and the loan can help build credit.
CD loan vs. early CD withdrawal
The cost associated with withdrawing early from your CD is a penalty that typically amounts to some of the interest earned, whereas the cost of a CD loan includes interest fees plus any additional fees such as origination or prepayment.
For example, let's say you have $15,000 in a five-year CD that's earning a 2.00% APY, and you opened it one year ago. You're thinking about borrowing $15,000 against your CD using a CD loan with an APR of 5.50%. Luckily, the loan doesn't have origination or prepayment fees. You could also take the money out of your CD, but you'd pay a penalty of about nine months’ worth of interest, which is close to the average early withdrawal penalty for a five-year CD, according to a 2019 DepositAccounts study.
Borrowing with a CD loan:
- You earn $1,561.21 in interest on your CD
- You pay $1,744.66 in interest charges on the CD loan
- You pay $183.45 in interest charges
- You earn $300 in interest on your CD
- You pay $201.17 as an early withdrawal penalty
- You earn $98.83 in interest
In this situation, it makes more sense to go ahead and take the money you need out of your CD, as you'd end up paying $98.83 less in penalties than what you already earned in interest during the first year of your CD. If you take out a CD loan, you continue to earn interest on your CD but end up paying $183.45 more in interest fees on the CD loan.
Alternatives to CD loans
It's also worth considering alternatives that don't involve taking out a CD loan or withdrawing from your CD before it matures. Consider each carefully, as there are costs involved with each alternative.
Tap your savings
The best option is almost always to pay in cash, to avoid the cost of borrowing money. If you've already got cash or an emergency fund, it's wise to use that instead. If not, look into selling some belongings or picking up extra work on the side to cover your expense without taking out a loan.
Get an unsecured loan
If you have to resort to a loan, you could also consider an unsecured loan. While these are more difficult to qualify for and tend to come with higher interest rates, they might be a reasonable option for someone with good credit. But like a CD loan, you should consider if it’s cheaper to take a CD early withdrawal penalty than to pay interest on an unsecured loan.
Use a credit card
Credit cards come with high interest rates, so they're generally not preferable to loans. However, if the expense you need to cover is something you can pay back quickly, a credit card could be useful. The best option is to pay off your credit card statement in full before it's due to avoid interest fees. However, if you need a little more time and have good credit, you could look into a low interest or 0% intro APR credit card.
If you're interested in taking advantage of the higher interest rates CDs can offer but worried that you might need to make an early withdrawal to cover an unexpected expense, you could always consider a no-penalty CD. These CDs might not offer the highest rates available, but they're still generous and give you the ability to withdraw your money without paying a penalty.
The final word: What to consider before getting a CD loan
CD loans can be an effective way to gain access to cash quickly, but going into debt comes with inherent risk and costs that might not be worth it. Make sure to do the math on your own and figure out whether it makes more sense to do an early withdrawal from your CD or take out a CD loan. You can also speak to your financial institution about other options, such as short term loans or credit cards.
Whatever you choose, it's wise to exhaust your options for paying with cash before resorting to borrowing money.