The ins and outs of certificates of deposits

Two questions have surfaced recently. First, how are penalties assessed when certificates of deposit are withdrawn early" That is, how much does the "substantial penalty for early withdrawal" really amount to? Second, when does it make sense to withdraw funds from a long-term certificate of deposit (CD) and switch the cash into a higher-yielding investment? With interest rates declining rapidly, there may be little benefit in considering a switch now, but conditions could change.

Rather than simplify penalties, the government agencies that control such things switched signals some months ago. For more than two years the penalty for early withdrawal was figured as a total loss of interest for three months plus a reduction of interest to the passbook rate in effect at the institution where you had your CDs. For an eight-year CD at a savings and loan, for example , the first quarter's interest would be lost, and your savings would be refigured to earn at 5 1/4 or 5 1/2 percent instead of 8 percent compounded daily or continuously. These are known as the "old rules."

New rules issues a few months ago give the bank or S&L the option of figuring the penalty as loss of interest for six months but no reduction of interest from the CD rate back to passbook rate. Generally, if your CD is relatively young -- say one year old -- you lose less under the "old rules." But if your CD is several years old, you lose less udner the "new rules." It's up to the S&L to decide rules apply. Some have adopted the hard line that, with interest rates high outside the CDs, the old rules will apply. Other institutions routinely figure penalties according to the new rules. You must ask you bank & S&L which rules apply in your case.

Not long ago, it might have made sense to pay the penalty and take money out of long-term CDs and put it into another investment, such as US Treasury bill (T-bill) related certificates of deposit. However, this plan can be faulted from two agencies:

1. Although 6-month T-bill CDs and Treasury bills themselves reached 15.7 percent one week, they offered that interest for only six months. The rapid fall of rates since then shows how easily yeilds can change.

2. Taking money out of insured savings and investing the funds in other, possibly riskier ventures troubles some conservative, older holders of long-term CDs. If you were to remove funds from eight-year CDs, pay the penalty, and invest the funds in utility income stocks, for example, you could assure a relatively high return in the neighborhood of 10-12 percent with possible long-term capital gains within 1 1/2 to 2 years. But such investments are not insured, and some risk is involved with the fluctuating price of the shares.

For an idea of the numbers involved, the United Retirement Bulletin (210 Newbury Street, Boston, Mass. 02116) for May 1980, figured the trade-offs for withdrawing funds from a $1,000 eight-year CD at 8 percent interest compounded daily and the interest yeild necessary to break even on an alternative investment.

For example, from their table an account balance of $1,275 for a $1,000 CD after three years would be penalized $109 for early withdrawal using the old rules. To break even, the owner of the CD would have to earn 10.41 percent for five years. Any return higher than that would be a profit; any less would be a loss. After seven years the penalty jumps to $307 and the break-even yield escalates to 31.3 percent for one year. The bulleting also figures similar break-even yields and penalties for four-year and six-year certificates.