What Are Certificate of Deposits?
A certificate of deposit (CD) is a note issued by a bank when an individual makes a deposit to the bank, often for a particular length of time. Basically, investors are lending money to the bank for a specified period. In return, the bank offers a higher interest rate to the investor than compared to a savings account or money market account. The higher interest rate is in exchange for not withdrawing the money from the bank for the period listed.
CDs offer a low risk method of investing. They are insured by the Federal Deposit Insurance Corporation (FDIC) for up to $250,000, so if your financial institution fails, your money is safe. Also, the length of term of a CD can be anywhere from a few weeks to a few years, making the funds as liquid as required. It is worth noting that deposits for longer usually have higher interest rates, as do larger deposits. Also, many banking institutions require a minimum deposit for a CD and there will be charges should the money be withdrawn before the end of the term agreed to.
What Are Brokered Certificate of Deposits?
Many people choose to invest in CDs offered by banks or such institutions, but that is not the only option available for investors. Instead of purchasing a CD directly from a bank, they can also be purchased through brokerage firms. CDs purchased from brokerage firms are referred to as brokered CDs and are slightly different from regular CDs.
Brokered CDs often offer an even higher interest rate than traditional CDs direct from the bank. This is due to the fact that the brokers can negotiate with the financial institution for a better rate by promising a certain number of guaranteed deposits to that institution. These types of CDs do carry a higher level of market risk compared to traditional CDs purchased directly from the bank though.
When you invest in a brokered CD, you may not be the sole investor. For many brokered CDs, there are a number of unrelated investors that all own a piece of the deposit, which allows for larger deposits with the financial institution. Larger deposits are another way that brokers can negotiate better interest rates for investors.
Finally, some brokerage firms may offer no penalties if you want to withdraw your money early. Based on the market, the broker may attempt to resell your CDs to another party, thus keeping the deposit with the institution. If they are successful in reselling your CD, then the early withdrawal fees are often waived.
Differences Between CDs and Brokered CDs
The basic differences between CDs and brokered CDs are:
Traditional CDs usually only offer short-term investing alternatives, while brokered CDs can have terms from as short as three months to as long as 20 years.
The rate for a traditional CD is locked for the length of the specified period and interest is usually only paid at maturity. The rate for a brokered CD is also locked, but interest can be paid periodically throughout the term (monthly, quarterly, annually, etc.) or at maturity.
Early withdrawals are allowed with traditional CDs, but there will be a penalty for such action. With a brokered CD, early withdrawals without penalty are allowed if there is a secondary market for purchasing your CD.
Depending on the length of term you choose for your CD, they are more susceptible to market volatility. Traditional CDs are short term in nature, so have a low inherent risk factor. Long term brokered CDs have a much higher risk as the rate is fixed for the length of the term. If rates increase markedly, you could be losing out on your investment, while the reverse is true if rates fall during the term of your CD.
There is also increased risk of fraud with brokered CDs. Brokers do not have to go through any certification and are not licensed or approved by any government organizations. When considering brokered CDs, you need to take the time to ensure the broker is legitimate.
Before investing in any type of certificate of deposit, it is important that you take the time to ensure you understand all that is involved and decide if it is a good investing tool for you.