How to Fight Back Against the Biggest Problem With CDs

Some very smart, charismatic, stylishly-dressed financial experts have dubbed 2024 the "Year of the CD," and there are good reasons for that. Many people are interested in CDs right now because they think the Fed might cut interest rates soon. Opening a CD can help you lock in on a high APY in advance of future rate cuts.

CDs have some good things going for them: fixed rate of interest, attractive yields, and FDIC insurance. When you open a CD, you know your money is going to be safe, and you know how much your savings will grow.

But there's one big problem with CDs: early withdrawal penalties. Let's look at why this could be a dealbreaker for your savings -- and how to fight back.

Why CDs charge early withdrawal penalties

When you open a CD, you are making a commitment. You are agreeing to deposit your cash in the bank for a specific length of time, or "term." Some short-term CDs might be just a few months, while others could be five years or longer.

Because the bank knows it's going to have your money for a certain amount of time, it can (often) give you a higher APY on your CD cash than you'd get from a savings account. This is what makes CDs a win-win: you and the bank agree to commit to each other, like a temporary mini-"marriage" for your money.

But what if that "marriage" ends sooner than expected? If you miscalculate the length of term that you can handle, if you run into financial trouble and need to use your CD as emergency savings, or if you get smitten with some other investment that you'd rather pursue instead, the bank is going to make you pay for jilting and abandoning your CD.

This is why banks charge an early withdrawal penalty. Think of it as a break-up fee, like "alimony" for your bank. The bank didn't get your money for as long as it expected, you changed your mind and broke your promise, and now your ex-partner (bank) demands compensation.

Early withdrawal penalties are nowhere near as costly as an actual divorce, but they still hurt. With a typical early withdrawal penalty, you might easily lose half or more of the interest that you've earned.

How to avoid early withdrawal penalties

Not earning interest on a CD defeats the purpose of putting money into that CD in the first place. You deserve a better way to save, without worrying about losing every dollar of interest.

Here are two easy ideas for how to avoid early withdrawal penalties, while still making your money grow.

1. Use a savings account

The best high-yield savings accounts pay APYs that are as high as (or higher than) the best CDs -- and savings accounts don't charge early withdrawal penalties. With a savings account, you can put more money in or take your money out at any time (as long as you don't exceed the allowed number of withdrawals per month). And the bank will never take half (or more) of your interest earnings away from you. Savings accounts might have lower APYs than CDs, but at least you don't lose money on the deal.

Before you open a CD, think carefully about whether the higher APY (if any) that you'll be earning from that CD is really worth the inconvenience and risk:

• Do you really want to lock up your money?
• How certain are you that you won't need that cash for the full length of the CD term?

Yes, if the Fed cuts interest rates soon, APYs on bank savings accounts will go down too. But unless you have so much cash in the bank that you have no worries about running out of emergency savings, the flexibility and safety of a savings account might be a better choice.

2. Open a no-penalty CD

Another way to fight back against early withdrawal penalties is to choose a special type of CD, called a "no-penalty CD." No-penalty CDs work in most of the same ways as a standard CD, but -- as the name suggests -- they have no penalties for early withdrawal. Because you get extra flexibility with a no-penalty CD, the APY will typically be lower than you could earn from a standard CD of the same term at the same bank.

Not every bank or credit union offers no-penalty CDs, and some no-penalty CDs are more flexible and "fee free" than others. For example, some financial institutions only allow customers to take cash out of no-penalty CDs during certain timeframes. The Ascent's picks for banks with some of the best no-penalty CDs include:

• Ally Bank
• CIT Bank
• Marcus by Goldman Sachs

Bottom line

No-penalty CDs are the only type of CD I would open -- and even then, you might get a higher APY from the best savings accounts. But if you want some of the advantages of a CD without losing the flexibility of a savings account, no-penalty CDs could be the best choice for your cash.