Don't Fall Into This Sneaky CD Trap

There's a reason so many people are rushing to open CDs today. The Federal Reserve spent much of 2022 and 2023 raising interest rates in an attempt to slow the pace of inflation. And while the central bank's efforts worked, they've unfortunately made the cost of borrowing more expensive for consumers across the board.

On the plus side, though, the Fed's actions have made it so that today's CD rates are the highest savers have been privy to in years. And the nice thing about CDs is that your interest rate is guaranteed -- whereas with a savings account, you could start out with a rate you're happy with only to see it fall due to market conditions.

If you bank at an FDIC-insured institution and you limit your deposits at that bank to $250,000 ($500,000 for a joint account), your principal is guaranteed. This means that if you open a CD paying 5%, that 5% is a guaranteed and virtually risk-free return. If you were to put money into stocks instead, you might score a higher return, but you'd run the risk of taking losses as well.

Still, there's a sneaky trap you risk falling into when you put money into a CD. But thankfully, there's also a pretty easy way to avoid it.

Our Picks for the Best High-Yield Savings Accounts of 2024

SoFi Checking and Savings APY up to 4.60% Rate info You can earn the maximum APY by having Direct Deposit (no minimum amount required) or by making $5,000 or more in Qualifying Deposits every 30 days. See SoFi Checking and Savings rate sheet at: https://www.sofi.com/legal/banking-rate-sheet. Min. to earn $0 Open Account for SoFi Checking and Savings Member FDIC.	APY up to 4.60% Rate info You can earn the maximum APY by having Direct Deposit (no minimum amount required) or by making $5,000 or more in Qualifying Deposits every 30 days. See SoFi Checking and Savings rate sheet at: https://www.sofi.com/legal/banking-rate-sheet.	Min. to earn $0
Citizens Access® Savings APY 4.50% Min. to earn $0.01 Open Account for Citizens Access® Savings Member FDIC.	APY 4.50%	Min. to earn $0.01
American Express® High Yield Savings APY 4.25% Rate info 4.25% annual percentage yield as of May 31, 2024 Min. to earn $1 Open Account for American Express® High Yield Savings Member FDIC.	APY 4.25% Rate info 4.25% annual percentage yield as of May 31, 2024	Min. to earn $1

When you're hit with a penalty that eats away at your returns

When you open a CD, you're committing to leaving your money in the bank for a preset period. In exchange for this commitment, banks tend to reward CD holders with higher interest rates than they give to people who stick to basic savings accounts. 

But for this reason, banks don't tend to take kindly to early CD withdrawals. So if you put your money into a CD but then end up needing the cash sooner than expected, you could face a costly penalty for removing your money before your CD matures.

Now, there's no such thing as a universal penalty for taking an early CD withdrawal. Rather, it depends on your bank. 

As one example, Capital One penalizes savers three months of interest for cashing out a CD of 12 months or less prior to maturity. Your bank is required to disclose what penalties it charges in your CD paperwork. If you open a CD online, you'll need to actually read through the electronic disclosures before making your CD official.

But either way, an early withdrawal penalty has the potential to eat away at the returns your CD generates for you. So it's best to avoid one if you can.

The best solution for avoiding an early withdrawal penalty

Tying up all of your money in a single CD increases your risk of getting hit with an early withdrawal penalty. So a much better bet is to construct a CD ladder.

Here's how that might work. Let's say you have $4,000 to put into a CD. Instead of sticking that entire sum into a single CD, you can put $1,000 into a 3-month CD, $1,000 into a 6-month CD, $1,000 into a 9-month CD, and $1,000 into a 12-month CD. This way, a portion of your money will free up every few months, which could reduce your chances of facing an early withdrawal penalty.

CDs can be a great way to earn money without putting your principal at risk. But make a point to ladder your CDs, so you don't fall into the trap of being penalized and losing out on interest.