Lost Opportunity Costs
Opportunity cost is the cost related to
what is being given up relative to an alternative. If an investor has a $100,000.00 CD earning 1.5%apy for
one year he stands to earn $1,500.00 interest. If an alternative investment
were available paying 4%apythat rate would generate $4,000.00 interest on his $100,000.00 investment. Because the investor chose the CD his opportunity cost was $2,500.00 ($4,000.00 - $1,500.00 = $2,500.00)
In this example if the 4% became available after the investor bought his CD at 1.5%, he may be better off paying a penalty to break the CD before maturity and reinvest the money at the higher paying rate. Let’s say the CD was 3 months old and the penalty on the CD to break it was 3 months worth of interest. The investor would receive a return of his $100,000.00 principal. If the investor reinvested the proceeds into the alternative paying 4% for the remaining 9 months of the original CD term, he would be further ahead. $100,000.00 earning 4% for 9 months is $3,000.00.
If the investor stayed in his original CD at 1.5% he would have $101,500.00 at the end of his term. By taking a penalty and reinvesting the proceeds at the higher rate the investor ended up with $103,000.00 in the same time period. The opportunity cost for the investor to stay in his CD paying 1.5% is $1,500.00. ($103,000.00 - $101,500.00 = $1,500.00) Now let’s take into account the CD penalty tax deduction and depending on which tax bracket the investor is in they will further reduce the net penalty thru a tax deduction. Contact us to see if you would be further ahead to get out of low paying investments before maturity for higher guaranteed rates.
How to Avoid CD Penalties
- Ask your financial institution or advisor, they may waive the penalty for you.
- Speak with a representative in person to find out what other options you may have.
- You may also qualify for a waiver of termination, such as death, disability, retirement, or other life events.
How much is a CD penalty?
Banks will typically charge you a penalty that amounts to some of the interest you would have earned if you held the CD to maturity. You might see it quoted as “90 days of interest” for early withdrawal. There is no maximum penalty amount.
Several institutions may have you pay 30 to 90 days of interest on CD’s that have less than a one-year term. For CD’s with a term longer than a year, you can expect to pay at least 90 days worth of interest. As the term lengthens, so does the penalty. Not all institutions are the same, so make sure you find out before you surrender your certificate.