October 17, 2016 in CDs

Deciding whether to go with a certificate of deposit offered by a bank or a brokerage sounds like it might be a no-brainer. Just pick the one with the best rate, right?

Before choosing, though, you should know the risks and rewards of buying and holding either type of CD. There are some big differences that can ding returns.

  • Bank CDs that you buy at your local bank branch are usually what we’d think of as traditional certificates of deposit.
  • Brokered CDs are bank CDs bought by brokers and then resold. They may have stiff fees and special features that can slash returns, plus brokerage CDs may not be as competitive and risk-free as you think.

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Brokered CD pros and cons

“Brokered CDs used to pay higher rates,” says Robert Laura, president of Synergos Financial Group in Howell, Michigan. Brokerages may still provide better rates, but not always.

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Brokered CDs do offer diversification among banks in different states. That makes it easier to ladder CDs, which is investing in several CDs with staggered maturities, says Herb Hopwood, president of Hopwood Financial Services in Great Falls, Virginia.

For investors parking more than $1 million, brokered CDs that can be diversified among many banks make sense because of the Federal Deposit Insurance Corp. insurance limit, which is $250,000 per depositor per insured bank. You’ll get more FDIC protection when you spread out your risk among different bank CDs nationwide.

Here’s another benefit of brokered CDs: Hopwood says when people buy lots of different CDs, they may forget when they’re scheduled to mature. Brokered CD purchases are usually listed on a brokerage statement, notifying you when maturity dates are approaching.

Key questions

Given these wrinkles, the key to buying a CD is knowing what you’re buying. Here are some questions that can get you started:

  • How much are fees? Fees can diminish returns, especially during low-interest times like these. And brokerage fees can run as high as 50 basis points (0.50%) per CD, Laura says. However, banks usually don’t charge fees on their CDs.
  • Where can you get the highest rates? If you have many accounts at one bank or a high balance of more than $100,000, you may be able to negotiate higher bank CD rates. Regional bank rates can vary dramatically from national ones.
  • What’s the early withdrawal policy? Banks typically charge an early-withdrawal penalty of 90 days’ worth of interest, but brokered CDs are different, Laura says. If you want to exit your investment, you must sell your CD on the secondary market, where CDs are sold by brokers and prices are driven by investor demand. That means you could lose principal, especially when interest rates rise and CD demand slumps.
  • How complex is the CD? Usually, brokered CDs are trickier and riskier than bank CDs. For example, many brokered CDs are callable, meaning that there’s a window of time — perhaps a year — when they can be yanked before they mature. That means locking in a good interest rate for a long time is harder to do, according to the SEC. But bank CDs are rarely callable. Says Laura: “That’s the main benefit.”
  • Who is the issuer? Brokered CDs typically are bought in bulk from one bank and then sliced into pieces. Sometimes these CDs are lower quality, meaning they may have lower safety ratings but offer higher yields. “They’re usually offered by institutions that need to raise funds,” Hopwood says. “They’re not always the strongest.”

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When to be careful

Take R-G Premier Bank of Puerto Rico, which failed in 2010. Its CDs were sold by brokers. “Brokers say, ‘Here’s the CD,'” Laura says. “But they may not lay out the bank’s financials.”

That means it’s up to you to identify and vet the issuer, not the broker. And if that bank fails, getting your money from a broker usually takes more time than getting it from a bank would.

“The process can take 60 to 90 days with a brokered CD,” Laura says. That’s time when your money isn’t being invested and earning interest. Conversely, bank depositors get their money faster, usually 7-10 days.

Also, a broker may unknowingly put your money into a CD at a bank where you already have deposits. Then, you may unknowingly wind up with a deposit that exceeds the $250,000 FDIC limit, warns the Securities and Exchange Commission.

On the flip side, local institutions that issue bank CDs are easier to vet and to follow. “But with a CD from a bank in Utah, you may not know it failed until it’s actually closed,” Laura says.

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