Read the rules before investing in a callable CD

If you are looking for higher yields with limited risk, a callable certificate of deposit (CD) may be for you. They promise higher returns than ordinary CDs and have FDIC insurance. However, before handing over the money to a bank or brokerage company, you should understand some of the matters in the fine print. Otherwise, you may end up disappointed.

Just like a normal CD, a redeemable CD is a certificate of deposit that pays a fixed interest rate throughout its life cycle. The difference between a redeemable CD and a traditional CD is that the issuer has a call option on the CD and can redeem or “redee” the full amount from you before the CD expires. Callable CDs are similar to callable bonds in many respects.

Key points

  • A redeemable certificate of deposit is a CD that includes a redemption function, and the issuing bank can redeem (redee) the CD in advance before its specified maturity date.
  • The redemption period is usually set within a given time frame and set at a preset redemption price.
  • Since these are called early will bring risks to investors, they usually pay higher interest rates than traditional CDs.
  • Higher interest rates may attract depositors, but they should read the fine print. Being called in advance increases the risk of reinvestment.

What is the callable date?

The redeemable date is the date on which the issuer can call up your certificate of deposit. For example, suppose the date of the call is six months. This means that six months after you buy the CD, the bank can decide whether to take back your CD and refund your money with interest. Every six months after the redemption date, the bank will again have the same option.

Changes in current interest rates are the main reason why banks or brokerage firms will recall your CD on the redeemable date. Basically, the bank will ask itself whether it has obtained the best deal based on the current interest rate environment.

What is the expiration date?

The expiry date indicates how long the issuer can keep your funds. The farther the maturity date is, the higher the interest rate you expect to receive. Make sure not to confuse the due date with the call date. For example, a two-year redeemable CD does not necessarily mature within two years. “Two years” refers to the period of time before you can call the CD away at the bank. The actual time you have to invest funds may be longer. You can usually find redeemable CDs with a maturity between 15 and 20 years.

When interest rates fall

If interest rates fall, the issuer may be able to borrow money at a lower price than paid to you. This means that the bank may take back the CD and force you to find new tools to invest in.

For example, suppose you have a one-year redeemable CD worth $10,000, with an interest rate of 5% and a maturity of five years. As the one-year redemption date approaches, the current interest rate drops to 4%. Therefore, the bank also lowered interest rates and only paid 4% for newly issued one-year redeemable CDs.

“Why should I pay you 5% when I can borrow the same $10,000 to pay 4%?” This is the question your banker is asking.

“This is your principal, plus the interest we owe you. Thank you very much for your business.”

Maybe you are counting on $500 in interest per year ($10,000 x 5% = $500) to pay for your annual leave. Now, if you buy another CD with a one-year period, you will only get US$400 (US$10,000 x 4% = US$400). Your other option is to try to find a place where you can pay 5% of funds, such as buying corporate bonds, but this may involve more risk than the $10,000 you want. The good news is that you get a higher CD rate within a year.

But what are you doing with this 10,000 dollars now? You have encountered the problem of reinvestment risk.

When interest rates rise

If the current interest rate rises, your bank may not call your CD. Why would it be? Borrowing elsewhere will cost more.

Going back to our previous example, let’s take another look at your $10,000 one-year callable CD. It pays you five percent. This time, suppose that by the time the redeemable date arrives, the current interest rate has jumped to 6%. You will continue to earn $500 per year, even if the newly released callable CDs are more profitable. But what if you want to withdraw your funds and reinvest them at a higher new interest rate?

“I’m sorry,” your banker said. “Only we can decide whether you can get the money earlier.”

Unlike a bank, you cannot get your principal back by calling a CD—at least not without a fine called an early refund of fees. As a result, you are stuck at a lower rate. If interest rates continue to rise while you are holding a redeemable CD, the bank may keep your funds until the CD expires.

Check the seller of the CD

Anyone can become a deposit broker selling CDs. There are no licensing or certification requirements. This means that you should always check with the securities regulator in your state to find out if your broker or your broker company has any complaints or fraud history.

Pay attention to early withdrawal fees

If you want to get the money before the expiry date, you may encounter surrender fees. These fees include CD maintenance fees and are designed to prevent you from trying to withdraw funds early.

You don’t always need to pay these fees-if you hold the certificate long enough, these fees are usually waived.

Check the issuer’s FDIC coverage limit

The FDIC insurance limit for each depositor of a bank or savings institution is USD 250,000. If your broker invests your CD funds in institutions where you have other FDIC insurance accounts, there are potential problems.

If the total amount exceeds US$250,000, you will be at risk of exceeding the FDIC coverage.

Bottom line

Considering all the extra troubles they involve, why should you bother to buy a callable CD instead of a non-recallable CD? Eventually, the redeemable CD transfers the interest rate risk to you, the investor. Because you take this risk, you tend to get a higher return than you would find using a traditional CD with a similar expiration date.

Before investing, you should compare the rates of the two products. Then, think about where you think interest rates will go in the future. If you are worried about the risk of reinvestment and prefer simplicity, a callable CD may not be suitable for you.

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