An important concern with long-term CDs is having your money locked into a low-rate CD when interest rates are increasing rapidly. With the possibility that we are moving into a period of rising inflation, that is a growing concern. DA reader kcfield made several good points in this DA Forum thread for savers to consider in today’s low-rate environment. As kcfield asked: “Should we give up our 0.50% interest savings account to invest in a 1% long term CD?” I think many savers and investors would agree with this opinion from kcfield:
In my view, giving up liquidity for such paltry gain is generally not a wise decision. During this time of such low interest rates, there are several options with better returns: paying down debt, making necessary major purchases, investing in the stock market, etc.
Liquid bank account alternatives to CDs
For money that you want to keep completely safe (like for an emergency fund, short-term goal or near-term expense), an FDIC- or NCUA-insured account is a reasonable option. There are federally insured liquid options that can be a good alternative to CDs. These include:
- High yield savings and money market accounts from online banks and credit unions
- High yield liquid accounts (savings, money market or checking) from fintechs that partner with banks
- High yield reward checking accounts from banks, credit unions and fintechs that partner with banks
I Bond alternative to CDs
For a small balance, there’s also the Series I Savings Bond (I Bond) that is a useful alternative to bank CDs when rising inflation is a risk. An I Bond purchased today from TreasuryDirect will at least keep up with inflation. Plus, it’s exempt from local and state taxes, and you can defer paying federal income tax until it is redeemed or until it reaches its 30-year maturity date. An important liquidity downside is that you can’t redeem it during the first year. Also, there’s a 3-month interest penalty if redeemed during the first five years. The I Bond option won’t help you for a large amount of savings. You are limited to a maximum purchase of $10k per calendar year for an individual (an additional $5k can be purchased via your federal tax refund). For more details on I Bonds, please refer to my latest I Bond review.
Risk that rates stay low for years
Savings, money market and checking accounts may have liquidity, but there is a risk that rates will stay low for years. Since I’ve been writing this blog for the last 16 years, there have always been concerns about being locked into a low-rate CD and missing out on higher rates. Most of the time, those expectations about higher rates in the future did not pan out, and savers earned more by locking into long-term CDs. Of course, the future may look much different than the past. However, the odds that rates may rise in the next few years may not be as high as you think. You may want to hedge your bets by not giving up on CDs.
Hidden CD risks
If rates stay low for the next several years, long-term CDs will likely allow you to earn more than what you could earn from savings and money market accounts. What happens if inflation keeps rising and that forces deposit rates to also rise? If the CD has a mild early withdrawal penalty (EWP), it should be easy for the depositor to do an early closure of the CD, take the penalty and reinvest the money into accounts with the new higher yields. There are two potential gotchas to this approach that we've discussed many times in the last 13 years:
- The bank refuses to allow an early withdrawal
- The bank increases the early withdrawal penalty on your existing CD
I consider the first risk to be the more worrisome. The increase of an early withdrawal penalty is possible as we learned with the Fort Knox FCU case. It should be noted that in the last 16 years the vast majority of banks and credit unions have honored their EWPs until maturity. In the rare case that the institution decides to not honor the EWP, an institution is required by regulations to provide affected members with a written change-in-terms notice at least 30 days before the effective date of the change. At least that gives us a chance to deal with the changes. If the institution is making a big increase in the penalty, customers should be able to close the CD before this change takes effect with the original early withdrawal penalty.
The risk that a bank refuses to allow an early withdrawal is more worrisome since it totally locks the depositor into the CD until maturity. There have been cases of banks refusing an early withdrawal. In my 2008 blog post, I reported on the experience of Chris at Jumbo CD Investments. He remembered two cases in which a bank refused to release funds. In one case, the bank ended up working with him and his client. They were able to have the bank release the funds after negotiating a higher penalty. The other bank would not budge, and it refused to release the funds.
If rates start rising substantially, banks and credit unions will have more incentives to refuse early withdrawal requests.
Minimizing the risks of CDs
If you are concerned with being locked into a CD, it makes sense to avoid banks and credit unions which include in their disclosures a clause that gives them the right to refuse an early withdrawal. Unfortunately, some banks and credit unions do have clauses in their disclosures which give them the right to refuse an early withdrawal. Some common clauses that I've seen include language like "only with the consent of the bank" or "if we permit an early withdrawal of principal". Look for banks with disclosures that give the CD holder the right to make an early withdrawal subject to the penalty. For example, I’ve seen disclosures that say "you may make withdrawals subject to the early withdrawal penalties stated below.” Note, banks often change their disclosures. Make sure you review their latest disclosure before deciding on their CDs.
It should be noted that one can only minimize the risk of a bank or credit union refusing to allow an early withdrawal. There will always be some risk that the institution won’t honor its CD disclosure or will use a vague section of their disclosure to justify its refusal. As we learned over the years, the regulators like the NCUA can’t be relied upon to enforce CD disclosures. It can take a lot of time and resources to successfully force an institution to honor its CD disclosure. This case of the Achieva Credit Union add-on CD is a good example of what it can take to win a fight against a credit union that doesn’t honor its CD terms.
Finding a safer CD
If you think some CDs for your “safe” money still makes sense incase rates don’t rise in the next few years, look for CDs with the following two attributes:
- CD has a low early withdrawal penalty. The best long-term CDs have EWPs of six months of interest or less. You can see how EWPs compare in this DA CD study.
- CD disclosure does not give the bank the right to refuse an early withdrawal request. Instead, it gives the CD holder the right to make an early withdrawal subject to the EWP.
Of course, the CD rate will always be an important factor to consider. Is the CD rate high enough compared to the rates of liquid account alternatives? If you feel fairly confident that you’ll be able to make an early withdrawal with the disclosed EWP, you can review the effective yields of CDs closed early (that factor in the EWP) during the term of the CDs by using our CD Early Withdrawal Penalty Calculator. In this EWP Calculator example, I compared the effective yields of 5-year CDs from two credit unions. Both have top rates, but their EWPs are very different. As you can see in this example, a CD with a 6-month EWP closed early may very likely beat the top savings accounts even if rates should happen to rise in the next year or two.
To find the highest CD rates, please refer to the DA CD rate table. You can choose terms from three months to six years and over. To review the EWPs, click on the “details” button at the end of each CD row. The row expands with details of the CD and the institution. One of the CD details is the EWP. If the EWP is not listed, the institution does not make its EWP information available on its website.