Callable CD’s
Someone recently asked about Callable CD's. What are they and how do they work?
For an example we will use a ficticious 2 year CD offer of 3%. During the life of the CD the bank has the option to end the CD, usually on the anniversary date. In our case that would be at the end of the first year. Thus your 2 year CD could become a 1 year CD, at the banks discretion.
Why is the bank doing this? The bank thinks that rates may go up to more than 3% at the end of the first year, but they are not 100% confident in that opinion. If rates do go up above 3% after the first year they will let you keep the CD, since it cost them less than paying the new higher rates. But, if rates don't go above 3% and stay at 2.75% (for example) they can call the CD and not have to continue paying more than the market rates.
So to summarize. With a Callable CD if rates go up you lose because you keep getting a rate that is lower than market. And if rates go down you lose if the bank calls the CD and you no longer get the higher rate. The decision by the bank to call the CD will not be made with your best interest in mind.
Suggest you consider laddering which puts the decisions and control in your court.
Again I would appreciate your feedback.
Best rates may be in your backyard
Several of my recent CD investment decisions have benefited from a search of local community institutions. Although the Best Rate services gather a tremendous amount of rate data they sometimes miss community banks and credit unions. These smaller organizations can be an excellent choice. You may have to visit them in person to open the account, but you could find some really good deals.
For example, Mechanics Cooperative Bank, Taunton, MA offered a 3.75% APY on a 5 year CD in early August, 2009.
Let me know if you have found similar opportunities in your local communities.
Many community banks and credit unions have stuck to the basics of their business. They are sometimes willing to pay a little above the going local market rates.
CD Penalties
Types of CD Penalties
The most common CD Early Withdrawal Penalties are the loss of a specific number of months interest if the account is closed before the end of the term (maturity date). For CD's of 1 year or less in term the penalty is most often 3 months interest. If the term is more than a year the penalty commonly is 6 months loss of interest. It is important to read and understand the early withdrawal penalty section of the disclosure provided by your financial institution.
It is important to understand how these penalties work. If for example you buy a six month CD and have to withdraw the money after only two months into the term you could face a three month interest penalty. In this case the CD has only earned two months of interest. Thus the penalty will be the two months of interest you have earned plus one month's interest is deducted from the amount you originally invested. In this example you could lose what you earned and some of what you invested.
You can minimize the possibility that you will incur these penalties by diversifying your CD holdings. Buy CD's with staggered maturities and multiple CD's of smaller amounts instead of a single large CD.
Minimize CD penalties
Penalties are incurred when a withdrawal of some, or all of the funds in the CD are withdrawn prior to maturity. These usually are the equivalent of three to six months interest that would have been earned on the deposits. It is important to clearly understand the penalties that are possible on the CD investment that you make.
Many people are concerned that they might need cash for an emergency at some point and are reluctant to make a long term commitment of their funds. One easy way to minimize this potential concern is to break the investment up into smaller pieces. If you have $6,000 to invest but are afraid you may need $800 before maturity for an emergency, consider the following. Purchase six $1,000 CD's instead of one $6,000 CD. The paperwork will take a little longer and the customer service person may not be happy, but you can now withdraw one or two of the CD's prior to maturity without paying the penalty that would have applied to the entire amount. Also, remember that six $1,000 CD's earn the exact same amount as one $6,000 CD. Look into the minimum deposit amount required for the particular CD that you are considering. Some institutions require only a $500 minimum deposit, thus in the previous example you could open twelve $500 CD's.
You can also request exception to the penalty on one of the $1,000 CD's because you are leaving the rest of your investment with the bank. They do want to keep your money, so negotiate to try and get a break on the penalty.
When Rates Are Down
Laddered CD's do extremely well when interest rates are going down. This is also a time when the economy may not be doing to well. If you have a 5 year ladder set up in this environment only 1/5th of your investment will be re-pricing at the current lower rates and 4/5th will stay at the higher earlier rates. Thus you end up dulling the effect of falling CD interest rates. Also, if you continue the ladder strategy you will be looking to replace that maturing CD with a long term CD which should offer a higher rate of return then a short term investment.
Why Invest in a CD?
The short answer is "preservation of principle" or "I don't want to lose what I have but I want to earn something from it without putting it at risk".
When you invest in stocks, mutual funds, bonds, a bank CD, or most any other investment the amount of money that you initially invest is sometimes referred to as your "principle". With almost all investment alternatives you are putting your "principle" at risk. That means you could lose some, or all of it. If you buy 100 shares of XYZ Corporation at $1/share and the price goes down to $.90/share you have lost $10 of your "principle". The same applies with almost all investments except CD's.
The only way you can lose any of your "principle" in a CD investment is if you withdraw the money before the term of the CD has concluded (see Types of penalties) or you invest more than the insured amounts at that financial institution (see Federal Deposit insurance and Other insurance).
Many people who have, or are nearing retirement age are only interested in preserving their "principle". They don't want to risk what they have accumulated in a 401(k) or other type of retirement plan. A CD accomplishes that goal very nicely.