So, you’ve been thinking about this a lot too, huh? Well, I’m glad you finally worked up the courage to ask. Let’s get into it.
Certificates of Deposit (or CDs, as we ‘in the biz’ like to call them) are a popular investment for all types of investors. Young. Old. Guys. Gals. Hell, even kids have them. Normally that’s courtesy of Mom, Dad, Grandma or Grandpa.
For anyone who may not have ever owned one before, a CD is essentially a time deposit investment. You deposit a sum of money with a financial institution for a stated period of time. In return, said financial institution gives you a stated rated of interest. Pretty simple concept. Or is it?
Some compound interest daily. Some compound interest monthly. Some don’t compound interest at all. Instead, they pay the stated interest at maturity. Make sure to always find the Annual Percentage Yield (or APY to the layman) so you know the actual rate you will earn. The APY is the effective annual rate of return taking into account the effect of compounding interest.
With all these choices and different ways of interpreting the rates of interest, how do you know which one is best?
Allow me to add another brick onto the wall. Let’s talk about the two main types of CDs; CDs from directly form a bank and CDs bought through a brokerage firm, called brokerage CDs. Pretty clever name for brokerage CDs, isn’t it?
For purposes of this discussion I’m going to solely focus on brokerage CDs that are FDIC insured.
For all intents and purposes, think of bank CDs are ones that you would walk into your local bank to purchase. Brokerage CDs are ones that you would most likely purchase through your Financial Advisor/Planner/Stockbroker or whatever else we’re calling ourselves these days.
There are three main differences between the two types of CDs that I’d like to highlight today:
- The way they’re cashed in prior to maturity. (Hey, things happen, right?)
- Potential fee(s) that are involved.
- Federal Deposit Insurance Corporation (FDIC) coverage.
Can we get hypothetical? Okay, let’s say you buy an 18-month term CD at your local bank. Let’s say you get a good CD rate too. After four months everything is great, except that you recently shattered your ankle playing basketball. Even with your major medical insurance coverage, it’s still going to cost you a ton of money. An arm and a leg (see what I did there?)
You need to cash in your CD early. At most banks, you will have to forfeit some interest in order to redeem your CD early. Not every single bank in existence, I’m speaking generally here. Some banks will impose a flat penalty to redeem early. Brokerage CDs, on the other hand, don’t normally require the forfeiture of interest, rather you generally sell the CD out on secondary certificate market to someone who is willing to buy it from you. Which leads me to the second way these two types of CDs are different, fees.
This one is really easy to explain. Bank CDs generally do not have any sort of fee(s) or commissions associated with them. Brokerage CDs ordinarily do. Albeit the fee(s) and/or commissions are typically small in comparison to other investment products (such as annuities, bonds, or mutual funds, for example) they exist none the less and you should be fully aware of them. If there isn’t a commission present for the transaction, there is, at minimum, probably going to be some sort of trading cost.
Told you that was an easy explanation.
Onto the last way they’re different; the way FDIC insurance can be utilized. Each depositor has coverage up to $250,000 per depositor, per institution. So, if you walk into your local bank with $750,000 and buy a CD in your name only, you’re not going to get coverage for the full $750,000, only $250,000 will be insured should the bank go under. Now, you could theoretically drive around to each bank in your area and buy a $250,000 CD at three different banks and get full FDIC insurance coverage that way if you want. Or, as an alternative, you could buy brokerage CDs. Brokerage CDs come from various banks all across the country. They give you flexibility with FDIC insurance. You could easily get your $750,000 fully insured by buying brokerage CDs with your Financial guy or gal because those brokerage CDs come from a litany of banks all across the Nation.
So those the three main ways brokerage CDs differ from bank CDs.
With all that said, the rates can vary from CD to CD and you should shop around for the best rate on a term you’re comfortable with. Be cognizant of any fee(s) and/or commissions on any brokerage CD. Be aware of FDIC insurance along with its limitations.