Ep.707: What Ia A Callable Certificate Of Deposit?

Dads Daughters and Dollars

A Regular CD

A certificate of deposit, or CD, is a type of savings account offered by banks and credit unions. You generally agree to keep your money in the CD without taking a withdrawal for a specified length of time. In general, in the past, the longer time frame of the CD, the more interest you would make. 5 year CD's would pay more than 1 year and 2 year CD's in general. Things have changed.

How a Callable Certificate of Deposit (CD) Works

A callable certificate of deposit (CD) is an investment that pays more interest and presents more risk than a traditional CD. When you purchase a callable CD, you are guaranteed a higher interest rate in exchange for the option to return the principal and interest to you before the CD matures.. The CD issuer can call a CD on its call dates. You know the call dates by looking at the coupon frequency. The coupon frequency could be semi-annually(every 6 months), monthly, or at maturity.

Why Banks and Credit Unions Do Callable CD’s?

Let’s say your callable CD is semi-annually or every 6 months. Thus, every six months, the bank decides whether or not to return the principal and interest of your CD to you or allow it to stay for another six months and earn you more interest. The call option exists in case market interest rates decrease, allowing the bank to close the CD early and avoid paying investors as high an interest rate.

Callable CD Example

Let’s say you buy a 3 yr. CD with a bank for $1000. The interest rate is 5%. It is callable. In one year that $1000 would earn $50 and after 3 years if the CD is not called you make $150. The CD will mature in three years, and the call date or coupon frequency occurs every six months.

Interest Rates go Down

Six months pass and interest rates don’t change significantly, so the bank decides to continue holding your CD. After nine months, interest rates have fallen 2% to 3%, but the next call date is still three months away, so the bank has to wait to call your CD. At the twelve-month mark, interest rates remain lower, so the bank calls the CD. It returns the $1000 principal and the $50 interest of your CD earned in one year. Now interest rates are 3% and you have to decide how to reinvest your money sooner than you may have expected.

Interest Rates Go Up

Let's look at a $1000 three year callable CD again. It's paying you five percent. This time, assume that nine months later interest rates have jumped to six percent 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.

Bottom Line

Know that the bank holds all the cards. Should rates go down, they are going to want to stop paying interest and call the CD. Should rates go up, they won’t allow you to cash in your CD without a penalty. Should you buy a callable CD make sure it is insured by FDIC for $250,000 by your bank.