Yesterday we wrote about how to create a CD ladder. CD ladders are a great way to take advantage of the high interest rates of long-term CDs and the liquidity of short-term CDs. But to be honest, they are a bit of a nuisance to create.
CD laddering requires you to open and manage multiple certificates of deposit. Once opened, you have to monitor the CDs and roll them over into longer term deposits until the ladder is complete. While that process is much easier with online banks, it can still be a hassle.
There is an alternative–open just one long-term CD that has a low penalty for early withdrawals. Ally Bank offers a 5-year CD with an early withdrawal penalty of just two months worth of interest. It’s the smallest penalty we’ve seen for a long-term CD. The current interest rate on the 5-year certificate of deposit is . Given this rate and withdrawal penalty, the 5-year CD is a great alternative to short-term CDs, regardless of whether you plan to create a CD ladder.
For example, let’s assume you invest $10,000 in a 5-year CD, but have to withdrawal your money after 12 months to handle an emergency. At 3% simple interest, you would have earned $300 before the penalty. Two months worth of interest would equal $50, so your actual return for the year would be $250, or 2.5%. (Because of compounding, your actual return would be a bit higher). So even with the penalty, the 5-year CD beats out the rate on a 1-year CD (currently about ) by a long shot.
The small withdrawal penalty has another benefit, too. One of the risks of long-term CDs is the chance that rates will rise and you’ll be stuck with the lower rate until the CD matures. But with such a small penalty, if rates rise significantly, you can still consider withdrawing the money, paying the penalty, and putting the money back into a new 5-year CD with the higher interest rate.