Imagine this — you find a 10-year, high-yielding certificate of deposit (CD) that’s federally insured and pays you enough monthly interest to cover your basic expenses. You might feel like your life is set for the next decade as you can just sit back and collect your guaranteed payments without risking any of your capital.
But then one day you get a notice from your bank saying they’re going to pay off the principal of your CD in only two years, and if you want to reinvest, you’ll have to accept a rate that’s only half of your original investment. That unfortunate scenario can easily play out if you buy a callable CD, so it pays to understand what they are and how they work.
Here’s a look at the ins-and-outs of callable CDs, including both their pros and their cons.
What Exactly Does ‘Callable’ Mean?
All CDs have a maturity date, which is the mandatory date that an issuer must pay back the principal value of the certificate. However, some CDs also have a callable date.
The callable date gives the issuer the option — but not the obligation — to pay off the CD in whole. As the call date approaches, the issuer must make a decision whether to return principal to investors or maintain their obligation until the final maturity date. If the issuer decides to call the CD, it will inform investors in advance, typically giving about 14-day notice.
What Makes an Issuer Call a CD?
An issuer will call in a CD when it makes financial sense to do so. Typically, this will be when market interest rates fall.
Imagine you buy a callable CD with an initial rate of 5%. If market rates fall to 3% by the call date, the CD issuer will almost certainly invoke the call provision, as it can then issue new CDs at the 3% rate and stop paying 5% on the money it borrows.
What Are the Typical Terms of a Callable CD?
CD issuers set the terms of their call dates, so they can vary from bank to bank and can come at any time. However, call dates are typically in the first half of the life of a callable CD.
For example, if you buy a 10-year CD, it may have a call date after three or four years. A four-year CD may be callable after one year, and so on. If the call date passes without being activated, the CD cannot be called before it matures — except in the rare instance when multiple call dates are listed.
What Are the Biggest Pros and Cons of a Callable CD?
A callable CD by definition gives an advantage to the issuer. If market rates fall, the bank issuing the CD can call it in and relieve its obligation to pay the higher interest rate. In exchange for this advantage, callable CDs typically come with higher-than-market rates when they are first issued. This is the biggest pro to buying a callable CD, since even if they are called, you may be better off in terms of total interest you have earned.
However, the initial yield boost offered by most callable CDs is often negated by the power the issuer has to call them in if market rates fall. Imagine a scenario in which you buy a 10-year callable CD with an interest rate of 5%. If your CD is called away after only two years and you are forced to buy a 3% CD, you may be “stuck” with that lower rate for the following eight years.
If you would have simply bought a 10-year, non-callable CD paying 4% at the outset, you could have earned that 4% for the full decade, rather than earning 5% for two years and just 3% for the following eight.
The Bottom Line
Callable CDs are still among the safest investments you can buy, as they carry FDIC insurance up to $250,000 and will not lose you money if you hold them to maturity. However, you may or may not be maximizing the return on your investment if you do buy a callable CD.
The callable provision brings a level of uncertainty to your cash flow, as the decision to call the CD remains entirely with the issuer. This may impact your overall investment strategy. However, if you understand what you’re getting into when you buy a callable CD, you may be able to enjoy above-average yields before its call date.
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