CD vs. savings account: The cost of an early withdrawal

Put money in a CD only when you are confident you will not need it before a fixed date and the CD pays at least as much as the best savings account you can get; keep everything else, including your emergency fund, in a high-yield savings account. The CD’s advantage is a locked rate, which pays off when savings rates fall during the term. Its cost is the early withdrawal penalty, and federal law sets a minimum penalty but no maximum, so the decision comes down to how sure you are about the date.

How each account pays you

A savings account pays a variable rate. Under Regulation DD, the bank must tell you the account is variable, but it does not have to warn you before it changes the rate, and savings rates tend to move with the Federal Reserve’s policy. This is the effective federal funds rate, the overnight rate banks charge one another, which is the benchmark those rates track:

A certificate of deposit pays a fixed rate for a set term, usually from a few months to five years. In return you agree to leave the money alone. Federal rules require a penalty of at least seven days’ simple interest on money withdrawn in the first six days, and above that minimum the bank sets the penalty itself; it is usually stated as a number of days or months of interest, and it must appear in the account disclosures you get before opening the CD. Longer terms tend to carry larger penalties, so read that line before you compare rates.

Two more rules are worth knowing. If your CD renews automatically and its term is longer than one month, the bank must send a notice before maturity: at least 30 days ahead, or 20 days before the end of a grace period of at least five days. And a longer CD does not always pay more. When markets expect rates to fall, banks sometimes pay less on long CDs than on savings, which is a sign that a lock is less likely to be worth much.

The $10,000 down payment, worked through

Say you have $10,000 for a down payment you plan to make in 18 months. An 18-month CD offers an APY of 4%, fixed, and a high-yield savings account pays the same today. Here is what each earns under three paths for savings rates (APY compounding, rounded to the dollar):

• Rates stay put: both earn about $606.
• Savings drops to 3% after six months: savings earns about $504, so the CD’s lock is worth about $102.
• Savings rises to 5% after six months: savings earns about $708, and the CD leaves about $102 on the table.

Now suppose the closing comes early and you need the money at month nine, with a penalty of six months’ interest. The CD has earned about $299 and the penalty takes about $198, leaving you around $100. The savings account would have paid $274 to $299 over the same nine months, depending on the path. One early withdrawal costs you roughly twice what the lock gains in the falling-rate case.

Break it at month three and the arithmetic turns negative: about $99 earned against the same $198 penalty. Whether the shortfall comes out of your principal depends on the account agreement, which is one more reason to read it before you sign.

The rule that falls out of this: the CD is worth it when the date is firm, the money is not your only cushion, and the CD’s rate is at least as high as the best savings rate available. If any of those fails, keep the money liquid.

Options between the two

• No-penalty CDs fix the rate but let you withdraw after the first week without a penalty. They usually pay less than regular CDs of the same term, and because of the federal minimum, even they cannot let you out penalty-free in the first six days.
• A CD ladder splits the money across several terms, for example $10,000 divided among 6-, 12- and 18-month CDs, so part of it comes free at regular intervals. It suits a goal with a fuzzy date.
• Treasury bills mature in 4 to 52 weeks and are backed directly by the U.S. government. Their interest is subject to federal income tax but exempt from state and local income tax, which favors them over CDs in high-tax states. You can buy them at TreasuryDirect or through a brokerage.
• Brokered CDs, bought through a brokerage, are FDIC-insured deposits at the issuing bank, but you normally get out early by selling on the secondary market, and the SEC warns you can receive less than you paid, especially after rates rise. Some are callable, meaning the bank can end them early when that suits the bank.
• Money market deposit accounts work like savings accounts, with a variable rate and deposit insurance, and some come with checks or a debit card.

Risks that get mixed up

With a CD, the risk during the term is rate risk: you lock in, rates rise, and you earn less than you could have. At maturity a CD faces reinvestment risk, the chance that when it matures you can only renew at a lower rate. A savings account has neither problem in that form; its risk is simpler, because the rate can fall the week after you deposit.

Default risk is the same for both and close to zero within the limits. Deposits at an FDIC-insured bank or an NCUA-insured credit union are covered up to $250,000 per depositor, per institution, per ownership category, and CDs count toward the same limit as your savings at that bank. Our guide to FDIC insurance limits shows how to stay under it with larger sums.

Making the call

1. Emergency fund or any money you might need on short notice: a high-yield savings account. Our emergency fund guide covers how much to hold there.
2. A fixed amount for a firm date at least six months away: compare the CD’s APY, its penalty, and the after-tax yield of a Treasury bill of similar length, and take the best of the three.
3. A goal with an uncertain date: a no-penalty CD, a ladder or savings.
4. Money you add to every month: savings, since many CDs accept only the opening deposit.
5. Before you open any CD: write down the maturity date and the grace period, and decide now what you will do with the money then, so an automatic renewal does not decide for you.

For a closer look at why online savings accounts pay what they do, see our explainer on where the high yield comes from.