When comparing long-term CDs, it's also a good idea to compare early withdrawal penalties in addition to rates. This is especially true these days when interest rates are at record lows and there's the possibility we'll see much higher rates in a couple of years. If rates rise enough, it can become worthwhile to break the CD, take the penalty and reinvest into a higher interest rate account.
Early withdrawal penalties can vary substantially. I have provided three examples in this post. The bank with the smallest penalty is Ally Bank which currently has only a 60-day interest penalty. I chose Pentagon Federal Credit Union (PenFed) as the one with the average penalty. PenFed has a 6 month interest-penalty on most long-term CDs (if closed after 6 months). EverBank's early withdrawal penalty is the most severe of the three, and it's not quite as straightforward. Here's what is stated in EverBank's disclosure for its Yield Pledge CDs:
This penalty will be equal to one-fourth of the total interest that would have been earned on the principal balance of the account if funds had not been withdrawn prior to the maturity date.
So for a 60-month CD, the penalty would equal 15 months of interest.
I have more details on the early withdrawal penalties of the above institutions in my post, Survey of CD Early Withdrawal Penalties from Internet Banks.
Below are examples of the effective annual yields if these 5-year CDs were closed after 1 year, 2 years, 3 years and 4 years from when the CD was purchased. The yields take into consideration the penalty. As you can see below, the yields get closer to the full yield as you get closer to the end of the term. Also note that the yields are approximate. I just did a quick calculation that will likely be a little off, but it's close enough for comparison purposes.
PenFed's 5-year CD: 3.50% APY as of 3/29/2010. Approximate effective APY if closed after
- 1 year: 1.75%
- 2 years: 2.63%
- 3 years: 2.92%
- 4 years: 3.06%
- 5 years: 3.50% (no penalty)
EverBank's 5-year CD: 3.39% APY as of 3/29/2010. Approximate effective APY if closed after:
- 1 year: -0.85%
- 2 years: 1.27%
- 3 years: 1.98%
- 4 years: 2.33%
- 5 years: 3.39% (no penalty)
Ally Bank's 5-year CD: 3.09% APY as of 3/29/2010. Approximate effective rate if closed after:
- 1 year, 2.58%
- 2 years, 2.84%
- 3 years, 2.92%
- 4 years, 2.96%
- 5 years, 3.09% (no penalty)
One interesting thing to note is that you can lose some of your principal if you close a CD within a period that's shorter than the number of months of the penalty. This is why the yield for EverBank for year one is negative. In addition to losing the first 12 months of interest, you would lose an additional 3 months of interest since the penalty is 15 months of interest (1/4 of 60 months).
Note, not all institutions will eat into your principal if you close a CD early. PenFed is one example. If you close a long-term PenFed CD before 6 months, you'll just lose all of the accrued interest, but none of the principal.
Another interesting thing to note above is the comparison between Ally Bank and PenFed. Even with a much lower rate, Ally has higher rates for year 1 and 2, but at year 3 both are equal, and then PenFed has higher rates for over 3 years. So if you think it's likely rates won't change much in 3 years, the PenFed 5-year CD would be a better choice.
Finally, it's important to note that some institutions include in their disclosures the right to refuse an early withdrawal request. Banks rarely make use of this right, but there have been cases where this has happened. I described some examples in this post on long-term CDs.
There have also been the concerns that banks could increase the early withdrawal penalty on existing CDs. Many had this concern for Ally Bank. I posted new information on this issue in this Friday post.