CDs or Certificates of Deposit are popular again.
With interest rates up, investors are once again rewarded for holding “safe” fixed-income instruments like FDIC-insured bank accounts and securities issued by the United States Treasury. That’s where CDs come in.
CDs are a type of fixed-interest rate deposit offered by banks. Most CDs are backed by the Federal Deposit Insurance Corporation (FDIC), a federal agency established by Congress that insures bank deposits. The FDIC arose as part of the New Deal during the Great Depression to provide stability and confidence to the banking system. Deposit insurance is limited to $250,000 per account per depositor per account ownership category.
Savers can buy CDs in two forms.
- The first – Bank Offered CDs – is the traditional way that most people are familiar with where a person goes into their local bank branch and open an account. Times have advanced a bit, and now CDs can be purchased through banks with nationwide footprints through the internet.
- The second way in which investors can buy CDs is by purchasing Brokered CDs in their brokerage account.
There are nuanced differences between these two forms of CDs and advantages and disadvantages to both. Let’s first look at a bank-offered CD.
Bank Offered Certificates of Deposit
Typically banks offer CDs with specific maturity dates. These are often between three months and five years.
Bank CDs do not allow early withdrawals without penalty. The interest accumulates and compounds at the promised fixed rate until the CD matures.
Local banks may let you open a CD with relatively small amounts.
Brokered CDs typically trade in units of $1,000 face value and some brokers may require a minimum purchase amount.
Unlike bank CDs, Brokered CDs trade in the market and can be bought with maturities typically from one month to 20 years.
Brokered CDs pay out interest on either a monthly or semi-annual basis depending on the terms of the CD. There is no early withdrawal penalty. If an investor wants to cash out, s/he simply sells the CD in the open market.
When you buy or sell a Brokered CD, you may need to pay a commission to your broker.
The Pros and Cons of Brokered CDs vs. Bank Certificates of Deposit
The Pros and Cons of these different flavors of CDs are important to understand. These considerations are general ones. Each deposit or investment needs to be evaluated for the details and specific terms.
Brokered CDs: Better Liquidity
Brokered CDs generally offer better liquidity. The commission to sell a brokered CD is usually cheaper than the early withdrawal penalty a bank will levy.
Brokered CDs: Wider Choice of Maturity Dates
There is a wider choice of maturity dates available with brokered CDs, including longer-dated CDs. This allows investors to better model their cash flow needs.
Brokered CDs: Better and Higher Interest Rates
With brokered CDs, higher rates can be locked in for longer. Sometimes brokered CDs carry higher interest rates than local banks because the banks that go out to the market with a brokered CD offering usually need or want deposits, so they are willing to “pay up” for them.
It is always a good idea to shop around for the best yields.
Brokered CDs: More Convenient and More Options
Having your CDs in your brokerage account along with your investments may be more convenient and easier to keep track of.
The ability to buy CDs from a wider variety than may be available in your local community bank could be a good way to diversify.
Brokered CDs: Easier to Preserve FDIC Protection
If you have more than $250,000 to place using brokered CDs may make it easier for you to spread the money around to preserve the FDIC protection on the entire amount.
Brokered CDs: Go Up and Down in Value
It is important to note that even though brokered CDs may offer better liquidity, these CDs, unlike the traditional bank-offered CDs, go up and down in value along the way to maturity. If you need to sell a brokered CD, market conditions might cause you to have a loss.
Bank CD: Stable-Value Investment
Those who want a stable-value investment (except for withdrawal penalties) might prefer the traditional bank CD.
Brokered CD: Callable by the Issuer
Sometimes, brokered CDs are callable by the issuer, meaning the issuing bank can pay off the principal amount of the CD early. This is important to be aware of and to consider when buying a brokered CD. You might think you have a great yield for a particular period but if the CD is called, you get paid the face value and the CD is over. Call features could cause you to lose money if you paid an amount over the face value.
Bank CDs: Compound Interest Earned at Fixed Promised Rate
It was mentioned that traditional bank CDs compound the interest earned at the fixed promised interest rate. Brokered CDs do not.
With a brokered CD, the interest is paid out to the owner in specified periods until maturity. It is up to the investor to re-invest the interest. If interest rates fall, the traditional CD has the advantage. The traditional CD earns interest on the interest at the promised rate. A holder of the brokered CD will be forced to re-invest each interest payment received at lower rates. If rates rise, then the Brokered CD allows the investor to re-invest at higher rates.
Bank CD: Better Local Bank Soundness?
Another point of caution with respect to Brokered CDs is that the soundness of your local bank might be better than some of the ones offered by your brokerage firm. There will still be FDIC insurance on an FDIC-backed CD but if a bank should fail, you might have to wait to get your money until the FDIC sorts it all out. It’s important to buy quality and not chase yield with a risky bank.
Taxable Interest for Both Types of Certificates of Deposit
Investors have lots of choices and all investments carry risks. It’s important to know the details and to find the best instruments for your needs. Interest on CDs is taxed at ordinary income tax rates. Investors should consult their tax professionals as part of their evaluation.
CDs can be owned in retirement accounts. From a tax perspective, this is something to consider.
Bank Certificate of Deposit vs. Brokered CDs: Which is Better for You?
Even though rates are more attractive these days, it is still important to consult with your financial advisor to see how CDs fit into your long-term asset allocation and investment goals.
If you would like to discuss purchasing a CD, please call Ian Green at 917-837-2287.
Thanks for reading.
Note: This blog article is intended for general informational purposes only. Nothing in it should be construed as, and may not be used in connection with, an offer to sell, or a solicitation of an offer to buy or hold, an interest in any security or investment product. Investing involves risk.
Image credit: “Security Safe Deposit” still bank, c. 1890, Iron, wood, pigment, Gift of Katherine Kierland Herberger, Minneapolis Institute of Art