Insurance Rates
Back to Home > Sunday, Sep 24, 2006 Business Posted on Sun, Sep. 24, 2006 email this print this
A few of you have told me I did a disservice to readers by failing to discuss callable certificates of deposit, including their pitfalls, in a column mentioning brokerage CDs.
Brokerage CDs, although sold by brokers, are bank-issued products with the same Federal Deposit Insurance Corp. protection as those sold directly by banks. They often pay higher interest rates than bank-sold CDs and don't impose early withdrawal penalties. You normally can sell these CDs before maturity.
Simply put, a callable CD is one that the bank can ``call'' or redeem before maturity, sometimes as early as six months after you buy it and every six months thereafter. When a CD is called, you get your principal back plus any accrued interest.
``A callable CD can work against you whether rates rise or fall,'' said Greg McBride, senior financial analyst for Bankrate.com. If rates fall, the bank could call the CD, leaving you to reinvest the returned principal at lower rates. If rates rise, you can get stuck for years holding a CD that's suddenly paying below-market rates.
In that case, if you try to sell the CD before maturity, you'll probably suffer a significant principal loss (prices of CDs move in the opposite direction of interest rates and, in broker jargon, there is ``limited liquidity'' for them in the ``secondary market.'' Translation: You won't find many takers for the CD you want to unload, and won't get a very good price).
Callable CDs do have an initial ``noncallable period'' when they cannot be redeemed. During that time, they will probably pay you a higher interest rate than you can get from traditional fixed-rate CDs. The longer the noncallable period, the more attractive a callable CD can be.
Another plus is if the interest paid by the callable CD is high enough to meet your needs until the stated maturity. Then, even if rates rise after you buy it, you are still getting a payout that covers your needs.
The standard advice, and it's good, is for most investors, and particularly seniors, to stay away from callable CDs with very long maturities, such as longer than 10 years.
For one thing, you probably don't want to tie up your money that long. And because of the way the math works with CD prices and interest rates, the longer the maturity, the greater the risk of a sizable loss if you have to sell.
One type of callable CD, the ``multi-step,'' changes rates at scheduled times. For example, a 10-year ``step-up'' callable CD I saw advertised recently paid 5.5 percent the first two years, 6.5 percent on years three through six, and 7.5 percent the last four years, for an overall annual percentage yield of 6.7 percent.
But the problem, and the reason I don't like these CDs, is that the bank typically can call them before any rate increase ever occurs. In the previous example, the bank could call the CD after just six months.
Inflation-adjusted CDs pay a lower initial rate that is adjusted periodically for inflation (the devil is in the details, and how the adjustments are calculated).
``Zero-coupon'' or ``growth'' CDs are long-term certificates that pay all interest at maturity. You know exactly how much you'll have at the end based on the annual percentage yield. In taxable accounts, you'll owe taxes each year on the accrued interest even if you can't spend it.
Equity-linked CDs pay rates ``based on'' (which doesn't mean the same as) stock market gains. Because details can vary widely, my suggestion is never to buy one unless you understand precisely how it works.
This is cache, read story here
A few of you have told me I did a disservice to readers by failing to discuss callable certificates of deposit, including their pitfalls, in a column mentioning brokerage CDs.
Brokerage CDs, although sold by brokers, are bank-issued products with the same Federal Deposit Insurance Corp. protection as those sold directly by banks. They often pay higher interest rates than bank-sold CDs and don't impose early withdrawal penalties. You normally can sell these CDs before maturity.
Simply put, a callable CD is one that the bank can ``call'' or redeem before maturity, sometimes as early as six months after you buy it and every six months thereafter. When a CD is called, you get your principal back plus any accrued interest.
``A callable CD can work against you whether rates rise or fall,'' said Greg McBride, senior financial analyst for Bankrate.com. If rates fall, the bank could call the CD, leaving you to reinvest the returned principal at lower rates. If rates rise, you can get stuck for years holding a CD that's suddenly paying below-market rates.
In that case, if you try to sell the CD before maturity, you'll probably suffer a significant principal loss (prices of CDs move in the opposite direction of interest rates and, in broker jargon, there is ``limited liquidity'' for them in the ``secondary market.'' Translation: You won't find many takers for the CD you want to unload, and won't get a very good price).
Callable CDs do have an initial ``noncallable period'' when they cannot be redeemed. During that time, they will probably pay you a higher interest rate than you can get from traditional fixed-rate CDs. The longer the noncallable period, the more attractive a callable CD can be.
Another plus is if the interest paid by the callable CD is high enough to meet your needs until the stated maturity. Then, even if rates rise after you buy it, you are still getting a payout that covers your needs.
The standard advice, and it's good, is for most investors, and particularly seniors, to stay away from callable CDs with very long maturities, such as longer than 10 years.
For one thing, you probably don't want to tie up your money that long. And because of the way the math works with CD prices and interest rates, the longer the maturity, the greater the risk of a sizable loss if you have to sell.
One type of callable CD, the ``multi-step,'' changes rates at scheduled times. For example, a 10-year ``step-up'' callable CD I saw advertised recently paid 5.5 percent the first two years, 6.5 percent on years three through six, and 7.5 percent the last four years, for an overall annual percentage yield of 6.7 percent.
But the problem, and the reason I don't like these CDs, is that the bank typically can call them before any rate increase ever occurs. In the previous example, the bank could call the CD after just six months.
Inflation-adjusted CDs pay a lower initial rate that is adjusted periodically for inflation (the devil is in the details, and how the adjustments are calculated).
``Zero-coupon'' or ``growth'' CDs are long-term certificates that pay all interest at maturity. You know exactly how much you'll have at the end based on the annual percentage yield. In taxable accounts, you'll owe taxes each year on the accrued interest even if you can't spend it.
Equity-linked CDs pay rates ``based on'' (which doesn't mean the same as) stock market gains. Because details can vary widely, my suggestion is never to buy one unless you understand precisely how it works.
This is cache, read story here
