Penalties

• The federal government requires that banks charge at least seven days worth of interest as a penalty if the money in the CD is withdrawn before the maturity date. However, the government does not specify a maximum penalty, so banks are free to set penalties as high as they want. According to Bankrate.com, on average, a 30-day CD will lose all interest, a two- to 18-month CD will lose about three months of interest and any CD that has a term longer than that can charge around six months of interest. These penalties can even take away some of the money you invested. For example, if you invested in a five-year CD with a penalty of six months' interest for early withdrawal and you took your money out after only three months, you would have to pay the additional three months' interest out of the original principal.
  
  

Necessity of Penalties

• When investors purchase CDs, they guarantee the bank that they will not take their money out early. This allows the bank to invest that money in long-term investments that have higher yields. However, if the investor suddenly demands their money, the bank is in trouble because it has invested that money elsewhere. This is the tradeoff investors make when they choose to invest in CDs with higher interest rates over savings accounts with easier access to money.
  
  

Interest Payment Options

• Interest on the CD can either be paid to you or reinvested in the CD. If you are investing in the CD because it will provide a steady stream of income, you are better off investing in a CD that will pay the interest monthly. If you are investing because of the higher interest rate, you would be better off having the money reinvested to increase future interest accruals.
  
  

Advantages of CDs

• CDs have a number of advantages over savings and checking accounts. They offer higher, guaranteed interest rates because of the promise that the money will remain in the account. CDs, along with your other accounts at the bank, are also insured for a total of $250,000 with the FDIC so you will not lose money like you might in a riskier investment like stocks or bonds.
  
  

Other Disadvantages

• Because of the guarantee on the rate, CDs usually earn less than riskier investments such as stocks and bonds. Also, if you invest in a CD, and interest rates rise, you are stuck with the rate that you agreed to, and you can't move the money without paying the early withdrawal fee.