Callable CDs: Check The Fine Print
If you're looking for bigger yields with limited risk, callable certificates of deposit (CD ) might be right for you. They promise higher returns than regular CDs and are FDIC insured. However, there are a few things in the fine print that you should be aware of before you turn your money over to the bank or brokerage firm, otherwise, you could end up very disappointed.
Just like a regular CD, a callable CD is a certificate of deposit that pays a fixed interest rate over its lifetime. The feature that differentiates a callable CD from a traditional CD is that the issuer owns a call option on the CD and can redeem, or "call", your CD from you for the full amount before it matures. In this article, we will provide you with some important terms to watch for in the fine print of your callable CDs , should you decide to invest.
Important Terms
Callable CDs are similar in many ways to callable bonds.
Callable Date
This is the date that the issuer can call your certificate of deposit . Let's say, for example, that the call date is six months. This means that six months after you buy the CD, the bank can decide whether it wants to take back your CD and return your money with interest. Every six months after the call date, the bank will have that same option again. We'll get to why the bank would want to call back the certificate shortly.
Maturity Date
The maturity date is how long the issuer can keep your money. The farther in the future the maturity date, the higher the interest rate you should expect to receive. Make sure you don't confuse maturity date with the call date. For instance, a two-year callable CD does not necessarily mature in two years. The "two years" refers to the period of time you have before the bank can call the CD away from you. The actual amount of time you must commit your money could be much longer. It's common to find callable CDs with maturities in the range of 15 to 20 years.
To Call, or Not to Call
A change in prevailing interest rates is the main reason the bank or brokerage firm will recall your CD on the callable date. Basically, the bank will ask itself if it's getting the best deal possible based on the current interest rate environment. (To learn how interest rate changes affect other investments , see How Interest Rates Affect The Stock Market and It's In Your Interest.)
Interest Rates Decline
If interest rates fall, the issuer might be able to borrow money for less than it's paying you. This means the bank will likely call back the CD and force you to find a new vehicle to invest your money in.
Example - Callable CD When Rates Decline
Suppose you have a $10,000 one-year callable CD that pays 5% with a five-year maturity. As the one-year call date approaches, prevailing interest rates drop to 4%. The bank has therefore dropped its rates too, and is only paying 4% on its newly issued one-year callable CDs.
"Why should I pay you 5%, when I can borrow the same $10,000 for 4%?," your banker is going ask. "Here's your principal back plus any interest we owe you. Thank you very much for your business."
The good news is that you got a higher CD rate for one year. But what do you do with the $10,000 now? You've run into the problem of reinvestment risk.
Perhaps you were counting on the $500 per year interest ($10,000 x 5% = $500) to help pay for your annual vacation. Now you're stuck with just $400 ($10,000 x 4% = $400) if you buy another one-year callable CD. Your other choice is to try to find a place to put your money that pays 5% such as by purchasing a corporate bond - but that might involve more risk than you wanted for this $10,000 . (For more on the risks of these bonds, see Corporate Bonds: An Introduction To Credit Risk.)
Interest Rates Rise
If prevailing interest rates increase, your bank probably won't call your CD. Why would it? It would cost more to borrow elsewhere.
Example - Callable CD When Rates Rise
Let's look at your $10,000 one-year callable CD again. It's paying you 5%. This time, assume that prevailing rates have jumped to 6% by the time the callable date hits. You'll continue to get your $500 per year, even though newly issued callable CDs earn more. But what if you'd like to get your money out and reinvest at the new, higher rates?
"Sorry," your banker says, "only we can decide if you'll get your money early."
Unlike the bank, you can't call the CD and get your principal back - at least not without penalties called early surrender charges. As a result, you're stuck with the lower rate. If rates continue to climb while you own the callable CD, the bank will probably keep your money until the CD matures.
What to Watch For
Who's Selling
Anyone can be a deposit broker to sell CDs. There are no licensing or certification requirements. This means you should always check with your state's securities regulator to see whether your broker or your broker's company has any history of complaints or fraud.
Early Withdrawal
If you want to get your money before the maturity date, there is a possibility you'll run into surrender charges. These fees cover the maintenance costs of the CD and are put in place to discourage you from trying to withdraw your money early. You won't always have to pay these fees; if you have held the certificate for a long enough period of time these fees will often be waived.
Check the Issuer
Each bank or thrift institution depositor is limited to $100,000 in FDIC insurance. There is a potential problem if your broker invests your CD money with an institution where you have other FDIC insured accounts. If the total is more than $100,000, you run the risk of exceeding your FDIC coverage. (To learn more, read Are Your Bank Deposits Insured?)
Wrap Up: Callable or Non-Callable?
With all of the extra hassle they involve, why would you bother to purchase a callable CD rather than a non-callable one? Ultimately, callable CDs shift the interest-rate risk to you, the investor. Because you're taking on this risk, you'll tend to receive a higher return than you'd find with a traditional CD with a similar maturity date.
Before you invest, you should compare the rates of the two products. Then, think about which direction you think interest rates are headed in the future. If you have concerns about reinvestment risk and prefer simplicity, callable CDs probably aren't for you.
Use this checklist when you are shopping for callable CDs to help you keep track of the important information.
Callable CD Checklist
Traditional CD Callable CD #1 Callable CD #2
Callable Date N/A
Maturity Date
Seller Background
Surrender Fee
Issuer
Interest Rate
