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Callable CDs: Higher reward, higher risk
By Laura
Bruce • Bankrate.com
Calling all CD savers!
As the stock market continues to scare the heck out of investors,
more money is being pumped in certificates of deposit -- and they're
safe and sound earners if you're aware of a couple of quirks.
If you buy a CD at a bank and patiently wait
for it to mature, you'll see every penny of your principal and interest.
But if you buy a CD at a brokerage, be on the alert for some differences.
Often, CDs sold by brokerages are callable.
You'll earn more than the going rate because you are essentially
taking a risk -- but if you're not aware of how callables work you
could lose if rates fall, or even if they rise.
The bank that issues the CD to the brokerage can pay you off after
a specific period, usually one year (only the institution
that issues the CD can call it).
Rate risk
Suppose you bought a two-year CD at 6.5 percent and the bank decided
to call it after one year. You'd just get one year's interest. Banks
would do this if interest rates had dropped. If you wanted to reinvest
your money in another CD after the first one was called, you'd have
to settle for the prevailing rate, which would be less than 6.5
percent.
"People are lured into callables because
they have higher interest rates," says Bankrate financial analyst
Greg McBride. "But the downside is that you may have to reinvest
at a lower rate if they are called."
In addition to the callable feature, the reason
CDs sold through brokerages generally have higher interest rates
is because brokerages buy them in huge chunks from banks and then
divvy them up to sell to you and me.
"But I thought ..."
Another potentially nasty problem with callables has nothing to
do with rates and everything to do with a simple, but common, misunderstanding.
State and federal regulators, such as the Securities
and Exchange Commission, say they're getting complaints from
investors who are confusing the callable date with the maturity
date. Investigators are looking into whether people are being misled
by some brokers into thinking "callable -- one year" means
the CD matures in one year and that's when they can get their money
back.
McBride says this misunderstanding can be a
costly mistake if you have to ask the broker to sell the CD, especially
if CD rates are higher.
"The date you think it matures comes and
goes. Nothing happens. But you expected -- and you need -- the money.
The CD hasn't matured so if you sell it you run the risk of losing
not only some of the interest you've earned, but some of your principal
as well.
"If the rates on CDs have risen, your CD
will go up for sale with a lower rate of earning than buyers can
get elsewhere. In this case the value of your CD is going to plunge
because the only likely buyer of a 6.5 percent CD won't want to
pay full face value on it.
"And FDIC insurance won't cover you,"
says McBride.
Watch your FDIC insurance
limit
There's one other potential problem to keep in mind and if you overlook
this one the risk can be substantial.
In addition to knowing the maturity date and
whether a CD is callable, know what institution issued the CD. McBride
says this is especially important if you have the $100,000 FDIC
limit in a particular bank. If the CD is bought at a brokerage but
your bank issued it, it will put you over the insurable limit.
And there are still a few more general cautions
to keep in mind.
Find out if there's an early withdrawal penalty
for cashing a CD before maturity. Some brokers advertise that there
is no early withdrawal penalty but don't expect to get all your
money back -- you'll only get what the broker can resell that CD
for and it may be significantly less than what you paid.
Know whether the interest rate is fixed or variable
and how the interest is paid. Do you have the option of being paid
directly by check -- and how often -- quarterly, semiannually or
annually? Or is the interest rolled into the CD?
Get everything in writing and don't sign anything
or pay any money until you have all the answers you need.
-- Posted: Oct. 27, 2000
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