Callable CDs offer higher rates than traditional CDs; but before you pounce, know the risks.

The promise of an all-inclusive vacation at a bargain price sounds like a dream-until you arrive and realize that the beach is eight miles away, the mattress is as hard as a rock, and the food is worse than what you'd get in a school cafeteria. Callable certificates of deposit (CDs) make dreamy promises, too, but there are stark realities to consider.

In the last six months, the Dow Jones Industrial Average, S&P 500, and NASDAQ have all taken beatings. The pronounced volatility has many people thinking twice about putting more money into equities right now. But with interest rates in the basement, cash deposits aren't attractive either.

Closer look at higher yields

If your banker or broker is pitching the callable CD as the middle ground, here's what you need to know before you commit. A callable CD is a variation of the traditional certificate of deposit, where your money is locked up for a specified time period in return for a guaranteed, fixed rate of interest. Callable CDs are tempting, because they often pay 0.5 to 1 percent higher than their conventional cousins. There's a trade-off, however.

A callable CD can be redeemed by the issuer prior to maturity. The terms of the CD dictate when this redemption can occur; in CD lingo, it can happen anytime after the call protection period expires. This can be a month or several months after you purchase the instrument.

Let's take a closer look. Assume you deposit $10,000 into a 48-month CD paying 4.5 percent interest, with a call protection period of four months.

  • Scenario 1. Shortly after you establish the CD, rates drop by 0.5 points. Your bank subsequently lowers its yield on the 48-month CD to 4 percent. Once the call protection period expires, the bank notifies you that your CD is being called. You're given the option to open a new CD at 4 percent.
  • Scenario 2. Shortly after you establish the CD, rates increase by 0.5 points. Your bank subsequently raises its yield on the 48-month CD to 5 percent. Now you're earning $450 a year, when you could be earning $500.

As you can see, the callable CD puts the interest rate risk squarely on your shoulders.

Crunching the numbers

You can make an informed decision about callable CDs by evaluating the numbers. Compare the rates between non-callable and callable deposits; if it's 1 percent, for example, that's only $10 of added interest per year for every $1,000 on deposit. When you aren't investing great sums of money, the added earnings potential of the callable CD may not be that significant. Now, compare the added earnings potential to the risk of having to reinvest at a lower rate before maturity. In that light, the callable CD may not seem so dreamy after all.

Published on December 21, 2010