You’re familiar with certificates of deposit (CDs) and how they work. However, you’ve recently come across what’s referred to as a callable CD and want to learn more about it to determine if you should add one to your financial portfolio. This guide dives into the specifics of these savings vehicles, including the pros and cons, how they differ from traditional CDs and who they’re best for. If you decide to move forward, you’ll also learn how to purchase a callable CD.
What is a Callable CD?
A callable CD is a type of savings product offered by banks and brokerage firms. Unlike its traditional counterpart, a callable CD can be “called” or redeemed by the issuer prior to the maturity date. In this case, you will receive the principal you invest and any interest earned up to that point.
These CDs are FDIC-insured, which means deposits of up to $250,000 are covered in the event of a bank failure.
How Callable CDs Work
As mentioned above, callable CDs come with a maturity date, which can be accelerated if the bank “calls” the CD. You’ll also get a fixed interest rate or annual percentage (APY), which yields predictable returns, assuming the CD is redeemed before the maturity date.
Why Would a Bank Choose to Call a CD Early?
Here’s why a bank might call a CD prior to the maturity date:
- Market conditions: If a bank expects interest rates to remain low, they may prefer to reissue CDs at current rates rather than pay higher rates on older CDs.
- Liquidity needs: Calling a CD early can free up cash that banks can use for other investments or lending opportunities.
- Financial strategy: Banks can better manage their liabilities by calling CDs prematurely.
Main Features of Callable CDs
Below is a closer look at the key features of these CDs.
Initial Fixed Interest Rate Period
Most callable CDs come with higher APYs than standard CDs during a certain period. It can last several months or even years.
Call Dates
Call dates are predetermined times when the issuer can choose to “call” or redeem the CD before its maturity. These dates are set when you purchase the CD, and they mark when the bank can opt to terminate it.
Call Premiums
In some cases, you might receive a call premium if the CD is terminated early. This premium is an additional payment as compensation for the bank ending the CD before the maturity date. Not all callable CDs include this feature, though.
How Callable CDs Differ from Traditional CDs
Here’s a closer look at the key differences between callable and traditional CDs.
Callable vs. Non-callable CDs
Again, callable CDs have a “call” feature, allowing the issuing bank to redeem or “call” the CD before it reaches maturity. But traditional or non-callable CDs do not have this call feature, so you’ll have a concrete idea of how long your money must sit to earn the advertised APY.
Interest Rate Comparisons
Callable CDs generally offer higher interest rates compared to traditional CDs. This is mainly because you take on the risk that the bank might call the CD before it matures. This higher rate is a trade-off for the uncertainty provided by the call feature.
Risk Considerations
With callable CDs, you face the risk that the CD may be called back when interest rates fall, meaning you could lose out on the higher interest rate you initially locked in. However, traditional CDs do not carry this risk and provide more stability.
The Pros of Callable CDs
There are many perks to investing in callable CDs.
Potential for Higher Interest Rates
Banks often offer these elevated rates as compensation for the call risk involved. If interest rates fall, the bank might choose to “call” or redeem the CD before its maturity. By taking on this risk, you may earn more than you would with a standard CD.
Predictable Income Stream
Callable CDs offer a fixed interest rate throughout the term, providing a predictable income stream. Unlike stocks, where dividends can fluctuate, the interest from callable CDs remains stable. Knowing exactly how much interest you will earn can assist in budgeting for future expenses or goals.
Backed by FDIC Insurance
Again, as long as you purchase a callable CD from an FDIC-insured institution, your investment is secured up to $250,000. This protection means that your principal investment remains safe even if the bank fails.
The Cons of Callable CDs
As with any CD, there are also downsides to consider.
Call Risk
The bank can take back the CD before its maturity date. This usually happens when interest rates fall, allowing the bank to refinance at lower rates. If your CD is called early, you’ll receive your initial investment and any interest earned up to that point. However, any future interest you expect will be lost.
Interest Rate Risk
Callable CDs often offer higher rates to attract investors, but these rates are not locked in permanently. If the bank decides to call the CD when rates drop, you’ll miss out on further earnings at the higher rate. There’s also the chance you might have to reinvest the funds into a CD with a much lower APY.
Liquidity Risk
This type of CD can also present liquidity risk. Your money is tied up for a fixed term, and accessing it prematurely can result in penalties. Since callable CDs can be redeemed by the bank but not by you before maturity without a penalty, this lack of flexibility might not suit those needing frequent access to their funds.
Can You Lose Money If Your Callable CD is Called Early?
If your callable CD is called early, you won’t lose money. As previously stated, the issuing bank will return your initial deposit. You will keep the interest earned up to that point, so your principal is safe.
Other Costs and Tax Considerations
Keep these costs and tax implications in mind if you’re considering a callable CD.
Interest Income Taxation
The interest you earn from a callable CD is considered taxable income. Regardless of whether you withdraw the interest or let it compound, you are responsible for reporting it in the year it’s earned. This means you’ll receive a form, usually a 1099-INT, detailing the interest income for your tax return. If you have a significant amount of callable CDs, it could push you into a higher tax bracket and mean a larger tax bill.
Penalties for Early Withdrawal
If you decide to withdraw your funds before the maturity date, you may face penalties. These penalties typically involve losing some of the interest you’ve accrued. In fact, you might forfeit several months of interest, which can impact your overall earnings from the CD.
How to Purchase a Callable CD
Are you ready to invest in a callable CD? Following these tips can help make the process as seamless as possible.
Researching Financial Institutions
Start by identifying financial institutions that offer callable CDs. This may include banks, brokerage firms and credit unions.
Compare the interest rates, minimum deposit requirements, and withdrawal penalties they provide. Look for reviews or customer feedback about these institutions to get a better feel for their reputation.
Consider factors like customer service quality, ease of access to your account, and the financial stability of the institution when you’re considering opening a callable CD.
Understanding Terms and Conditions
Carefully examine the terms and conditions of the callable CD before proceeding. Pay special attention to the policies surrounding the potential for the CD to be called, interest rates and any associated fees.
You should also understand what happens if the issuer decides to call the CD early, as this can affect your expected returns. Note the calling schedule, which is the time frame when the issuer can redeem the CD before its maturity date.
And confirm any penalties for early withdrawals if you decide to access your funds ahead of schedule to help avoid surprises later on.
Making the Investment
Once you’ve selected the financial institution you’d like to open a callable CD with, the final step is to make the actual investment or deposit the required funds.
Most banks let you apply for a callable CD online, although you may be required to visit a physical branch to move forward. Just be sure to have a copy of your photo identification card handy, along with the routing and account number of the account you’ll use to fund the callable CD.
Once you’ve made the deposit, await confirmation of your purchase. Be sure to keep all documentation and account information secure. Doing so will help you track your investment and manage it effectively over time.
Who Should Consider Callable CDs?
Suitable Investor Profiles
If you have extra cash that you do not need to access frequently, you might consider a callable CD. Older adults or retirees with a conservative investment approach might appreciate the potential for higher returns while still maintaining some level of security.
Those familiar with CD and bond investments may already have a good grasp of the callable feature and how it might fit into their portfolio. If you have experience with callable bonds, you might already understand the call risk involved with these CDs.
Financial Goals Alignment
Callable CDs are ideal for investors looking to meet more medium-term financial goals. These could include saving for a new vehicle purchase or a down payment, funding higher education costs or building up enough funds to invest in a new business venture.
More specifically, they should not require immediate access to their funds and should be okay with the idea of leaving the funds locked away in exchange for a higher return than they’d earn with a regular savings account. Investors should also not take issue with the potential for the CD to be called before reaching the date of maturity.
Risk Tolerance
Your level of comfort with financial uncertainty plays a big role in deciding if a callable CD is appropriate.
Remember, callable CDs carry a unique risk: the possibility of being called early by the issuer. If you can accept this level of uncertainty and don’t have an immediate need for the funds, you might be a viable candidate for a callable CD.
