How sneaky CD gotchas can cost you money

With interest rates on the rise, certificates of deposit (CDs) may not seem like the best place for your cash. That's because a CD rate is typically fixed for its entire term, while the rate of a savings and money market account can increase while your money is parked there. Still, even though deposit rates are finally rising, the move has been very gradual, and based on recent actions from the Federal Reserve, that's unlikely to change anytime soon.

Instead of waiting for higher rates on a savings account, they're available today on CDs. The best CD rates are often from specials, but before jumping into a CD special or any CD, make sure you're aware of these potential gotchas that could cost you money.

Customers who don't review their CDs when they mature may get stuck in a CD with a much lower rate. Be extra careful to remember maturity dates of CD specials, which often renew into standard CDs with much lower rates.

You're free to close the CD without a penalty at maturity and during the grace period, which can range from five to 20 days after maturity. However, if you forget about maturity and misses the grace period, it could mean getting stuck in a new CD with a disappointing rate. Then you have to either wait for the new CD to mature or take an early-withdrawal penalty.

Making matters worse, many banks and credit unions have increased their early-withdrawal penalties in the last few years in preparation for rising interest rates. Always review this penalty on new CDs and CDs that have been renewed.

You might want to withdraw money from a CD before maturity for several reasons. You might need the money for an emergency. You might find other opportunities for that money that could earn a higher interest rate. That becomes more likely when rates are in a rising cycle.

If the CD has a mild early-withdrawal penalty, it can make financial sense to close the CD, take the penalty and redeploy the money into a new higher-rate CD. However, if the CD has a large early-withdrawal penalty, it's less likely it will make financial sense. You may be better off waiting until maturity.

That's the reason many banks and credit unions have raised their early-withdrawal penalties in the last few years. One example is an internet bank that increased the penalty on its five-year CD from six months of interest to 18 months of interest.

Another important fact about many early-withdrawal penalties is that they can reduce your principal. If the penalty exceeds all interest that has been earned, the penalty may then subtract from the principal. For example, if a depositor closes a five-year CD nine months into the term and the early withdrawal penalty is 12 months of interest, all nine months of interest that has accrued will go to pay the penalty. In addition, the bank may reduce the principal by an amount equal to three months of interest. So it's possible to lose money in a bank account.

Not all banks and credit unions have CD early-withdrawal penalties that can eat into your principal. Some have a penalty that's the lesser of all interest earned or a certain number of months of interest. In this case, if the penalty is 12 months of interest, and a CD is closed nine months into the term, the penalty will equal all interest earned, and no money will be subtracted from the principal.

To avoid these CD gotchas, take the time to research the CD before you apply. Information about early-withdrawal penalties is often difficult to find. Make sure to review the CD disclosure or truth-in-savings document before you apply for the CD. The details of the early-withdrawal penalty should be described in these documents.

Also, research the bank's procedures that cover CD maturity. Some banks and credit unions will give you the option to transfer funds from the CD to another account at maturity. If your bank doesn't, make sure to set up a calendar alert so you don't forget when your CD matures.

Careful review of CD details with some planning will ensure you avoid these costly surprises.

Ken Tumin is founder and editor of DepositAccounts.com, which has been tracking and rating the savings, CD and checking account offerings of banks and credit unions for more than a decade.