What Is an Callable Certificate of Deposit (CD)?

What Is an Callable Certificate of Deposit (CD)?
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If you've already set aside emergency funds in a savings or money market account and are looking for higher returns, purchasing certificates of deposit may be the next step.

Traditional CDs are safe and give you the certainty of a fixed return over several years. However, rates for CDs offered by banks are constantly changing, so it pays to shop around for the best return.

For higher returns with limited risk, a good choice might be callable certificates of deposit. They usually pay higher rates than normal CDs, and they're FDIC insured.

What Are Callable Certificates of Deposit?

A normal certificate of deposit is set up for a specified amount, a fixed interest rate and a maturity date. An example would be a $5,000 CD paying 2% interest that matures in three years. The issuing bank is obligated to pay you this rate for the life of the CD and return your money at maturity.

A callable CD also has a specified amount, a fixed rate and a maturity date. The difference is that the bank has the right, a call option, to redeem the CD and return your original investment to you at any time after a lock-up period.

The call feature means that at any time past the call date specified in the fine print of your CD, the bank can decide they want to terminate your CD, pay you the accrued and give you back the original investment.

With a callable CD, the investor bears the risk of fluctuating interest rates. The callable CDs offered by MidFirst Bank are good examples of these terms, maturities and redemption policies.

What Is a Call Date?

The terms of a callable CD state that the bank cannot redeem the CD until after a specified date. This is the CD’s “call date.” The span of time between the opening of the CD and the call date is the lock-up period.

Suppose your $5,000 callable CD that matures in 3 years has a call date of six months after the date of issue. In this case, the bank cannot “call” your CD for the first six months. However, the bank has the right to redeem your CD at any time after six months, all the way up to maturity.

What Happens If Rates Go Up?

In a market of rising interest rates, the bank is not likely to call your CD. They would rather continue paying you a lower interest than redeem your CD and have to pay another investor a higher market rate on a new CD.

The problem for a CD investor in a rising interest rate market is missing the opportunity to earn more from the higher rates. One way to solve this problem is to invest in a series of CDs, a process known as a CD ladder, with different maturity dates. This strategy will create the availability of funds maturing at different times that could then be reinvested in new CDs at the higher CD rates.

Your CD ladder could be made up of callable CDs with different maturities.

What Happens If Rates Go Down?

When interest rates are declining, banks have the incentive to redeem their callable CDs. They can close out higher-rate callable CDs and replace them with new CDs at lower rates. This swap lowers the bank’s borrowing costs and increases their profits. The availability of callable CDs with attractive rates will decline if banks believe that interest rates will continue to drop.

This is the primary risk that investors face when purchasing callable CDs. An investor who has a CD called now has to find another place to earn a better return.

What Is the Reinvestment Risk?

If your CD gets called, you will get your money back and have to more than likely reinvest in a market with a lower rate. This is the risk you take with a callable CD: being forced to find another investment in a market with interest rates going down.

If you believe that interest rates will continue to fall, you want to keep your investments short term to have funds available and be in a position to take advantage of locking in higher rates when the market turns up.

What About Early Withdrawal Penalties?

Just because the bank has the right to redeem your CD and return the money to you doesn't mean that you have the same privilege. As with normal CDs, if you want to make a withdrawal from your CD before its maturity, you must pay early withdrawal penalties. Usually, this means you forfeit all or part of the interest accrued from the opening of the CD to the date of the withdrawal.

Your investment strategy should include a projection of your future needs for funds. Some callable CDs may allow for penalty-free withdrawals at certain times and under specific circumstances. You have to read the terms and conditions of the CD to know the terms for early withdrawals to decide whether or not the higher return is worth the risk.

Are Callable CDs Worth the Increased Risk ?

As with any investment, callable CDs have their advantages and disadvantages.

Pros:

  • Pay higher interest rates than normal CDs with same maturities, normally 0.5% to 1% higher
  • Have fixed rates that protect against drop in interest rates
  • Are FDIC insured up to $250,000
  • Have no risk of losing your original investment

Cons:

  • CD may be called before maturity if interest rates go down, forcing investors to find alternatives
  • Could lose interest gains in the future if rates go up because funds are locked in until maturity
  • Have penalties for early withdrawal that could result in loss of accrued interest

If you plan on staying up to date with changes and trends in the market for interest rates, then callable CDs are an attractive option to consider. Staying current on interest rates means keeping up with financial data and the direction of the economy. You have to study this information to develop a sense for the direction of interest rates to judge if the higher return of callable CDs justifies the risk.

On the other hand, if you're a risk-averse investor who likes to put their money away and not have to worry about or try to make predictions of shifts in the market, locking in fixed rates with normal CDs would probably be a better choice.