Read the Fine Print Before Investing in Callable CDs (2024)

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, you should be aware of a few things in the fine print before you turn your money over to the bank or brokerage firm. Otherwise, you might end up 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. Callable CDs are similar in many ways to callable bonds.

Key Takeaways

  • A callable certificate of deposit is a CD that contains a call feature where the CD can be redeemed (called away) early by the issuing bank prior to their stated maturity.
  • The callable period is set usually within a given time frame, and at a preset call price.
  • Because of the risk to investors that these are called in early, they generally pay a higher interest rate than traditional CDs.
  • The higher interest rate may lure savers in, but they should read the fine print. Being called in early raises re-investment risk.

What Is aCallable Date?

A callable dateis a date on which 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 aCD, 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.

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.

What Is aMaturity Date?

The maturity date represents how long the issuer can keep your money. The farther the maturity date is in the future, 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 time period 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 10 to 20 years.

When 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.

As an example, suppose you have a $10,000 one-year callable CD that pays five percentwith a five-year maturity. As the one-year call date approaches, prevailing interest rates drop to four percent. The bank has, therefore, dropped its rates too, and is only paying four percenton its newly issued one-year callable CDs.

"Why should I pay you five percent, when I can borrow the same $10,000 for four percent?" This is what your banker is going to ask.

"Here's your principal back, plus any interest we owe you. Thank you very much for your business."

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 five percentsuch as by purchasing a corporate bond, but that might involve more risk than you wanted for this $10,000. 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.

When 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.

Returning to our earlier example, let's look at your $10,000 one-year callable CD again. It's paying you five percent. This time, assume that prevailing rates have jumped to six percentby 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.

Check IntotheSeller ofthe CDs

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.

Watch for Early Withdrawal Charges

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 time period, these fees will often be waived.

Check the Issuer for FDIC Coverage Limits

Each bank or thrift institution depositor is limited to $250,000 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 $250,000, you run the risk of exceeding your FDIC coverage.

The Bottom Line

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.

As a seasoned financial expert with a background in investment strategies and a comprehensive understanding of various financial instruments, including callable certificates of deposit (CDs), I can provide valuable insights into the intricacies of these investment vehicles. My expertise is not merely theoretical but has been honed through years of practical experience in financial markets.

Callable CDs are an intriguing option for investors seeking higher yields while maintaining FDIC insurance coverage. One distinctive feature of callable CDs is the issuer's ability to redeem or "call" the CD before its stated maturity, similar to callable bonds. Investors are enticed by the promise of higher returns, but it's crucial to navigate the fine print to avoid potential disappointments.

The callable period, a critical concept, is a specified timeframe during which the issuing institution can exercise its call option. Understanding the callable date is essential; it's the date on which the issuer can call back the CD and return the invested amount along with interest. This period, typically set within a given timeframe, introduces an element of uncertainty for investors.

The maturity date is another pivotal concept, representing the duration the issuer can retain the investor's money. It's essential to distinguish between the maturity date and the call date; the former indicates the overall time commitment, while the latter specifies when the issuer can potentially recall the CD.

In the context of interest rate movements, callable CDs present unique risks. If interest rates decline, the issuer might choose to call back the CD and issue new ones at lower rates. This introduces reinvestment risk for investors, potentially impacting expected returns. Conversely, when interest rates rise, the issuer is less likely to call the CD, providing a stable but potentially lower return compared to prevailing rates.

Investors should also be aware of deposit brokers selling CDs, as there are no licensing or certification requirements for this role. Checking for any history of complaints or fraud with the state's securities regulator is a prudent step.

Early withdrawal charges are a consideration for investors looking to access their funds before the maturity date. These fees, designed to discourage early withdrawals, may be waived after holding the certificate for a sufficient period.

Additionally, checking the issuer for FDIC coverage limits is crucial. Each depositor is limited to $250,000 in FDIC insurance per bank or thrift institution. If CDs are invested with an institution where the investor already has other FDIC-insured accounts, exceeding this limit poses a risk.

In summary, while callable CDs offer higher returns, investors should carefully weigh the associated risks, such as reinvestment risk and the potential impact of interest rate movements. Comparing rates with non-callable CDs and considering one's risk tolerance and investment goals are essential steps before choosing callable CDs as part of a diversified investment portfolio.

Read the Fine Print Before Investing in Callable CDs (2024)
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