Understanding the fundamentals of callable CD’s
A callable CD is a certificate of deposit that yields higher returns but without any risk. These CDs are also FDIC regulated and therefore have limited risks than other CDs. In these CDs the issuer of the CD is free to choose a call option on the money invested in the CD and can cash in the whole money before the maturity date and pay back to the investor.
Important terms used in Callable CD’s
- Callable Date – This is the date within the maturity period when the issuing bank of the Callable certificate of deposit will have the right to use the call option and return the invested amount of the customer along with the earned interest to him.
- Maturity date - Maturity date refers to the amount of time the issuer can keep the money with himself. The longer the date of maturity in any kind of CD investment, the greater will be the interest earned. The maturity date is different from the callable date as the callable date lies within the maturity date.
- Call option - This term refers to the right of the issuer to break a CD maturity term mid way and returns the principal amount and the interest to the customer.
Conditions that affect the calling by a user
The callable CD issuer makes a call mainly when the interest rates change.
- When there is a decline in the interest rate the bank will use the call option. When the interest rates fall the issuer will also have the option of borrowing money from other sources at a lower rate than that it is currently paying to its customer. This will make him call the high interest rate Callable CDs before their maturity date.
- Increasing interest rates will prevent the bank from making calls on the CD’s. This is because if it makes a call it will have to pay higher rates of interest from other financial sources to borrow money.
Disadvantages of Callable CDs
Callable CDs have longer periods of investment and result in higher yields than other CDs. But the problem lies in the fact that the CDs can be called by the bank and other financial institute on the basis of the rising or falling interest rates. This fails in giving the investor the opportunity to get a fixed income on a larger premium amount.
The call option can be availed only by the issuing bank and not by the investor. An investor is not allowed to withdraw the money within the maturity date.
In case the investor withdraws the money before the maturity date, the penalty levied is high.