What it means
A traditional certificate of deposit (CD) locks your money for a set period, such as one year, in return for a fixed interest rate. If you take the money out early, the bank charges a penalty, often equal to several months of interest.
A liquid CD removes or greatly reduces that penalty, so you can leave if a better opportunity appears or if you need cash. Because the bank cannot count on keeping the money for the full term, it pays less interest.
The gap between a liquid CD rate and a standard CD rate is the price of flexibility, and it varies with the bank and with market conditions. Terms often include a waiting period, such as the first week after funding, during which withdrawals are not allowed.
Some banks require you to withdraw the entire balance rather than part of it. Interest earned is normally taxable in the year it is paid, and in many countries deposits are protected up to a limit by a government insurance scheme, subject to the rules in each place.
Businesses and individuals use these products to park cash that might be needed at short notice, such as an emergency fund or money set aside for a property deposit. They are also useful when rates are expected to rise, since the holder can withdraw and reinvest at a higher rate without penalty.
The decision comes down to whether you are likely to need the money before the term ends. If you are confident you will not, a standard CD pays more.
If there is a real chance you will need it, the lower rate of a liquid CD may be cheaper than the penalty. A simple way to compare is to work out the interest given up each year by choosing the liquid option, then compare it with the penalty you would pay if you withdrew a standard CD early.
If the penalty is much larger and early withdrawal is plausible, the liquid CD is usually the sensible choice.
In practice
Real-world examples.
Example
A small business owner has $40,000 set aside for a possible equipment purchase in the next six months. She places it in a liquid CD so that she can withdraw it as soon as the supplier gives a delivery date, without losing interest. If the purchase is delayed, the money simply keeps earning.
Example
A retiree expects interest rates to rise over the next year. He chooses a liquid CD so that he can move his money into a higher-paying product when rates go up. He sets a reminder every quarter to compare his rate with the best available offers.
Example
A couple saving for a house deposit puts $30,000 into a liquid CD. When they find a property earlier than expected, they withdraw the whole amount with no penalty. The interest earned up to that date stays with them.
Formula
Calculation
Simple interest = principal x annual rate x time in years.
Suppose you deposit $25,000 for one year. A liquid CD pays 4.0%, so interest = 25,000 x 0.04 x 1 = $1,000. A standard CD pays 4.5%, so interest = 25,000 x 0.045 x 1 = $1,125. The cost of liquidity is 1,125 - 1,000 = $125 for the year, which is the premium you pay for the freedom to withdraw early, and the rates here are illustrative only.Case study
Seen in the real world.
Kestrel Print Works is an illustrative, fictional small company that held $60,000 of spare cash. The owner considered a standard one-year CD that paid 0.5 percentage points more than a liquid CD, which on $60,000 would add 60,000 x 0.005 = $300 over the year.
However, the company expected to buy a new press at some point in the year and could not be sure of the timing. The early withdrawal penalty on the standard CD was three months of interest, which would have cost about 60,000 x 0.045 x 0.25 = $675 if the money was needed early.
In this illustrative case, the owner chose the liquid CD, accepted the lower rate, and withdrew the money in month seven for the press. The extra interest given up was at most $300, which was less than the $675 penalty the standard CD would have charged, so the choice protected the company from a larger loss. The owner now compares the likely penalty with the rate gap before placing any deposit.
Watch out
Common mistakes.
- Assuming a liquid CD has no rules, when many require a waiting period after funding before withdrawals are allowed.
- Choosing the highest rate without considering whether you may need the money, when a penalty can wipe out months of interest.
- Forgetting that a CD usually has a fixed rate, so a liquid CD does not rise when market rates rise unless you withdraw and reinvest.
Questions
People also ask.
Is a liquid CD the same as a savings account?
No, a liquid CD has a fixed rate and term, whereas a savings account usually pays a variable rate and allows withdrawals at any time.
Can I withdraw part of the balance?
It depends on the bank; some allow partial withdrawals, while others require you to withdraw the whole balance.
Is my money protected?
In many countries bank deposits are covered up to a stated limit by a government scheme, but you should check the rules and limits in your own jurisdiction.
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