Safety First For Savings
The highest rate certificates of deposit (CD) are usually offered by banks that may be on the FDIC Problem Bank List. A troubled bank usually has difficulty attracting deposits due to the risk of a banking failure and is therefore forced to offer a higher CD rate to attract funds – see Signs Of A Problem Bank – High CD Rates.
The purchase of a higher rate CD from a problem bank does not carry anymore risk than purchasing a CD from a well capitalized bank as long as the amount of the deposit does not exceed the FDIC deposit guarantee limitations (usually $250,000). Savers are currently collecting very small interest rates on CDs due to the Federal Reserve dropping short term interest rates. In order to earn a higher yield on savings, it is certainly worth considering the purchase of a higher yielding CD from a problem bank since the deposit is fully guaranteed by the FDIC.
Many brokerage houses and financial companies sell FDIC insured CDs to investors and these are known as “brokered CDs”. Although they are fully guaranteed by the FDIC (up to insurance limits) the risk in purchasing brokered CDs is that if the bank fails, brokered CDs are usually paid off by the FDIC. The risk to the investor in purchasing brokered CDs is the reinvestment risk. An investor who purchased a high rate CD for 5 years and is paid off early by the FDIC if the bank fails, may have to invest the funds at a lower rate if CD rates declined since the time of the initial purchase.
Be Very Cautious of CD Rates Far Above The Average Rate
The old saying “if it sounds too good to be true, it usually isn’t” should never be ignored. Earlier this year, many savers lost billions of dollars investing in very high yield CDs that they thought were FDIC insured but were not. Here is what the FDIC had to say recently about the risk of investing in CDs with rates far above the competition.
Beware of an advertised CD rate far above the competition. First, it could be a product issued by a company that is not federally insured and any money invested is at risk. Second, it could be a marketing ploy. “An offer of a very high interest rate may be a lure to promote the sale of non-insured products,” said Richard M. Schwartz, an FDIC attorney who specializes in consumer issues. “Some non-bank companies are using the FDIC logo and good name to draw customers in the door for a bank CD, but sooner or later, they’re going to try to lock them into a long-term investment that may not be in the customer’s best interest.”
In one variation, a company may advertise in the local newspaper a 5.0 percent interest rate for a six-month bank CD for consumers with $10,000 to invest. When a customer calls, he or she is told to come to the office to discuss the details. It turns out that the bank is paying only 2.5 percent — not 5.0 percent — but the sales person for the company offers to add enough money to the CD purchase to make up the difference. When the CD matures, there’s no similar offer on a new CD and the individual can be steered into purchasing a non-insured investment that may be a poor choice for the consumer but very lucrative for the sellers.
Schwartz offers this final advice: “If you are purchasing a CD, verify that it is issued by a federally insured depository institution. Understand the interest rate and the terms offered. Finally, research the going interest rates from banks locally and around the country, and if you find an offer that sounds too good to be true, be aware that there will definitely be strings attached.”
The FDIC also offered the additional advice to those shopping for a CD.
Shopping for a CD – Be Informed – Be Safe
What is the interest rate? Can the interest rate go up in the future? Ask about any features that may allow you to earn a higher rate if market rates go up in the future. But also remember that a CD with more flexible terms than a traditional, fixed-rate CD may be offered at a lower interest rate. When does the CD mature? Are there options for early access without a penalty? If not, what is the penalty? Think about how long you are willing to leave funds in a CD but also ask what would happen if you needed money back sooner than expected.
You may be able to get a good deal on a bank CD sold by a brokerage firm, but it also may come with extra risks and costs. Although most savers purchase CDs through local banks, firms known as “deposit brokers” compare rates at several banks and sometimes negotiate a higher interest rate by promising to bring a certain amount of deposits to an institution. But a broker-sold CD can be complex and may carry more risks than purchasing a CD directly from a bank.
Consider “laddering” your CD purchases over different time periods. Say you have $10,000 to invest and you’d like to maximize your earnings but you’re hesitant about investing long term. Instead of putting it all into a five-year CD just to get a high, long-term interest rate, you could place $2,000 in a CD that matures in a year, $2,000 in a CD that matures in two years, and so on, which means you’ll have a CD maturing every year for five years.
Deposit with confidence knowing that federal deposit insurance of $250,000 will continue through 2013. Congress has extended the temporary insurance limit of $250,000 per depositor (up from $100,000 per depositor) from December 31, 2009, through December 31, 2013.
Will the CD automatically renew at maturity if I don’t withdraw the money? If that’s the case, find out if the automatic renewal will be at the “old” interest rate or the current rate at the time of the renewal. If market rates have increased, it is not to your benefit to renew at the old rate.