Callable bank CDs may be worth the risk

By Laura Bruce • Bankrate.com

When you’re looking to wring every cent out of fixed investments, a callable certificate of deposit may be an option.

Callables got a flurry of bad press not long ago when regulators accused some brokerages of deliberately misleading elderly clients about the terms of the CDs. But not all callable CDs are bad investments, and most issuers of callables don’t try to scam people.

A callable CD can be called, or redeemed, only by the institution that issues it. The call period usually begins one year after the date the CD was issued. Normally, a bank or brokerage would call a CD if interest rates drop.

For example, if you bought a five-year callable CD at 6 percent, the bank might call the CD after one year if interest rates on five-year CDs had dropped to 5 percent. You’d collect the 6-percent interest for the year and would receive a 5-percent annual percentage yield for the remainder of the term.

A few institutions will give you the option of selecting one of their other CDs or even cashing out.

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We’ve had to call quite a few CDs lately with interest rates dropping as much as they have, says Daniel Adams, vice president of Oklahoma City’s MidFirst Bank.

But a lot of the customers come in and sign up for another callable. They can go into any of our products that they want to. They can close the CD. It’s their option. We want to keep them as a customer.

MidFirst is one of the relatively few banks issuing callable CDs. Most banks have chosen to stick with noncallables when dealing directly with their customers.

Callable CDs have been predominately the territory of brokerages, which buy large quantities of CDs from banks at a discount and then are able to offer a higher rate by making the CD callable. That way they’re not stuck with a high interest-rate CD when rates drop.

The callables that got the bad press were sold by brokerages, matured in 10 or 20 years and were inappropriately sold to older investors who might not live that long. Furthermore, regulators say, investors were led to believe that the one-year callable period was when the CD matured.

Directly issued callables

Clearly, there are many reputable brokerages that sell callable CDs and have no intention of defrauding anyone. But let’s focus on callables that are directly issued by banks to their customers. None have terms longer than five years.

The good thing about callables is the premium you get for investing in a CD that can be yanked out of your hands before it matures. A lot of people are willing to take that risk in return for additional interest, often a quarter-percent or half-percent higher than noncallables.

Generally, our customers love the callable CDs, says Eugene Lucci, vice president of marketing at Cleveland-based Charter One Bank.

There are customers who definitely don’t want callables. Maybe they don’t understand there’s a premium. But many customers, all they have are callables. They love the fact that there is usually a premium, and they’re willing to accept the call feature because of the premium.

Lucci brings up an important point — usually there is a premium. At the time of our interview, Charter One was offering a 24-month callable with a yield of 3.50 percent. The noncallable two-year had a 3.25 percent APY. But two months earlier, both CDs had an APY of 3.25 percent, and Charter One’s noncallable CDs have a $500 minimum deposit, while the callable minimum is $2,000.

If you’re taking on the risk of the CD being called, be sure you’re getting a premium interest rate.

When we price a callable, our treasury department tells us what the value of that call option is and we pass it on to the customer in the form of interest rate, says MidFirst’s Adams.

Right now the value of the call option on the three-year is 15 basis points (a basis point is one-hundredth of 1 percentage point.) Would a customer be attracted to that? Probably not. I don’t anticipate we’ll get a lot of three-year callables, but we have a lot more room on the five-year.

MidFirst’s callable five-year has a 4.40 percent APY vs. 3.80 percent on the noncallable.

While most five-year callable CDs give the customer a year before the CD can be called, some shorter-term CDs might be called in six months.

We’re very clear with the customer up front, says Adams. We have a separate page that’s nothing more than the callable disclosure that the customer signs. It says they understand the bank can call the CD after one year, and for the 24-month CD it’s a six-month call.

We found a couple of banks that offer five-year callable CDs that require a minimum deposit of $25,000. Both banks assume customers will cash their interest payments instead of reinvesting them. One bank does not allow interest to be reinvested. Neither bank provided a representative for this report, but it’s important for you to question the bank regarding its rules on CD interest payments.

Ask about the penalties

When you buy a callable CD, ask about penalties for early withdrawal. They can be stiff. Charter One charges 90 days interest at the certificate rate, and then the interest earned is calculated at the bank’s current passbook rate.

Banks want to discourage customers from cashing CDs, so make sure you’re not tying up cash you may need.

If a bank doesn’t call your CD after the initial call period, it doesn’t necessarily mean you’re free and clear to earn the same interest rate for the remainder of the term.

Some institutions will give themselves just one shot at calling a CD, but most will reserve the right to call it for either a specific term, say, every six months after the initial call option date, or they may say they can call it at any time.

Buying a callable CD is a more complicated decision than buying a noncallable because of the greater number of variables at each institution.

As First Union and Wachovia complete the process of integrating the two banks, callable CDs — a successful product at Wachovia — will be offered to customers. Customers who purchase a callable will know in advance the lowest rate they would receive on the remaining term if the CD were called, says Larry Fuschino, Wachovia Corporation vice president.

They’ll have a rate that they’ll receive, and they’ll also be told a floor rate. If we call the CD after the first year, the new rate the customer would be offered would not be below the floor rate.

Here is a checklist to help in deciding whether to buy a callable CD. Keep in mind; each bank may have its own parameters for callables. Get everything in writing, and read the fine print.

Maturity date: Find out when the CD matures. That’s when you can cash the CD without penalty and receive all the interest. Don’t confuse the maturity date with the call date.

Call date: This is when the bank can redeem or call the CD prior to the maturity date. If the institution terminates the CD, you’ll get the principal and interest. Otherwise, your money may be reinvested at a lower rate for the remainder of the term.

FDIC coverage: Bank and brokerage CDs are deposit products and are supposed to be covered by Federal Deposit Insurance Corp. insurance.

Penalties for early withdrawal: Know how much interest you’ll sacrifice if you cash the CD before maturity. Many banks will take three, six, or even 12-months interest if you withdraw early. Some banks will penalize you beyond that by reducing the interest you receive for the remainder of the term that you held the CD.

For instance, if you cash a five-year CD after three years, the bank may deduct six months interest and then pay you passbook-rate interest for the remaining 2.5 years.

Interest: The bank should show you a rate and an annual percentage yield. The rate is what you’ll get with simple compounding. The yield assumes interest payments are reinvested.

Reinvesting interest: Is interest automatically reinvested? Can you receive interest payments by check or electronic transfer every quarter, semiannually or annually? Are there any fees involved for this service? Does the bank prohibit reinvestment of interest on a particular CD?

Premium: This is the difference between the bank’s APY on a callable CD vs. the APY on the bank’s noncallable CD that has the same maturity. When you buy a callable CD, you’re taking a risk that the CD will be called and you’ll have to reinvest at a lower rate. The bank or brokerage should pay you a premium for this risk.

Is this investment right for you?: CDs carry heavy penalties for early withdrawal. Make sure you won’t need the money before the maturity date.

— Posted: Aug. 26, 2002