A primer on no-penalty CDs

A no-penalty CD can give you the best of both worlds -- a guaranteed rate of return with the ability to withdraw your money any time.

A no-penalty CD is exactly what the name suggests: a CD that allows you to withdraw your money without paying a penalty.

Early withdrawal penalties are one of the defining characteristics of CDs. You sign on to keep your money in a CD for a particular term. In exchange for your commitment, the bank gives you a higher interest rate than they would on a savings account. If you break the deal, you pay a penalty on your earnings. In same cases, you'd even lose part of your original deposit.

That seems pretty straightforward and fair. But obviously if you could have the security and high interest rate of a CD without the early withdrawal penalty, you'd take it. What's the catch?

Interest rates often lower than traditional CDs

For starters, no-penalty CDs typically have lower interest rates than traditional CDs. This makes sense: like a savings account, you're free to withdraw your money at any time. Since the bank needs to keep it relatively liquid, they can't pay you as high a premium for depositing it with them.

So why would you do this? There are two advantages to a no-penalty CD.

Rates rise, you win.

In an economy where interest rates are rising, you retain the flexibility to chase those rates up. You lose some money at the outset by not having the higher rate of a fixed-term CD, but you can withdraw your funds and earn the new high rates as soon as interest rates increase significantly. This is great for investors who want the security of a CD but want to stay at the leading edge of rising interest rates.

Rates drop, you win.

The other scenario where a no-penalty CD can serve you well is in a falling rate market. In this scenario, your interest rate is protected, just as it would be with a traditional CD. Unlike a traditional CD, though, you can access your money at any time. With interest rates low, a no-penalty CD will probably still give you a higher rate than a money market account.

Not all no-penalty CDs have lower interest rates. Large banks are sometimes able to offer no-penalty CDs at the same or even slightly higher rates than their traditional CDs. Compare CD rates to find the best deals available on no-penalty CDs.

Is a no-penalty CD right for you?

A no-penalty CD lets you take advantage of a higher interest rate than your savings account would give you, with more flexibility about when you withdraw your funds.

A no-penalty CD is a particularly good choice if you want to invest some money for an indefinite period of time. For example: you know you'll have a large home repair expense coming up in the next 2-3 years, but you don't know when exactly you'll need access to your funds.

A no-penalty CD can't be treated like any other savings account, though. There's still likely to be a "withdrawal timeline", which could be anywhere from a week to three months.

Another option for investors seeking the security of a CD and the flexibility of no-penalty withdrawals is a short-term high-yield CD. These will give you the highest interest rate available, with a short turnaround to free up your money. You'll be free to invest it elsewhere at the end of the term if interest rates rise.

These short term CDs can be a great choice for growing your travel nest egg or setting aside next year's college tuition.

How to choose a CD

Like any financial tool, a no-penalty CD is only as good as the return it brings you on the dollars you invest. These CDs won't be right for every investor, or every dollar of any investor's savings. To get the most out of your CD, find one that's right for your needs. That might or might not be a no-penalty CD.

To find the right CD, you'll want to bear in mind: how much flexibility you need to withdraw your funds, the term of your investment, and most of all, the interest rate.

To get started, compare CD rates here on SavingsAccounts.com. Bank of America offers a "No-Risk CD" that lets you transfer funds from it to another Bank of America account without penalty. Ally Bank offers a no-penalty CD whose interest rate is frequently competitive with traditional CDs.

Banks know that customers want the best possible deal on their savings dollars. In a competitive banking market, they try to come up with ever more creative offerings for their customers. One of these is the no-penalty CD. They're not doing you a favor; they're competing for your money by offering you a variation on their service that they hope will give them an edge over the other bank down the street.

Don't let confusion about the different kinds of CDs cause investor paralysis for you. If you have some money saved and you'd like to get a better interest rate on it (who wouldn't?), do a little research and get started with a relatively short-term CD. You can keep your eye on interest rates and adjust your investment as each CD matures, but at least you'll have your toes in the high-interest waters of CDs.

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