You may have noticed that brokered certificates of deposit (brokered CDs) are offered as an investing option by your wealth advisor or online investing platform. You may also be enticed by the better interest rates offered by brokered CDs, while also wondering about the extra fees charged for them. What gives?
Like traditional CDs, brokered CDs are interest-bearing accounts that have a set term and yield. But instead of depositing money in a bank’s CD, you purchase brokered CDs through a middleman — your stock broker or financial advisor. These middlemen buy CDs in bulk from banks, negotiate higher rates, and charge extra fees.
Taken together, these factors make investing in the brokered option a different experience than depositing money in traditional CDs. Let’s take a look at the differences and help you understand when buying a brokered CD may give you an investing advantage.
What is a brokered CD?
Think of these CDs as investment products that are more like stocks, bonds or mutual funds than a bank deposit account. They are called “brokered” CDs because investment funds and brokerages purchase CDs from banks, credit unions and thrift institutions, and then resell them to you.
When middlemen buy CDs from banks, they shop around for the best rates and purchase from different sources. In addition, they buy in CDs in bulk. Taken together, these factors let them offer their customers more competitive rates — and some other key advantages — but it’s also why they charge fees for that extra convenience and yield.
Brokered accounts generally credit you with simple interest rates rather than compounding interest. Holders of the brokered option normally get paid simple interest monthly, quarterly, semi-annually or annually. Simple interest is calculated only on the principle you deposit in your brokered CD account. If you invest $10,000 at an interest of 3%, you will earn $300 in interest at the end of the year, and there will be no compounding of that interest at given intervals.
Bank CDs must be held to maturity, and if you withdraw your money early, you’re charged a penalty. Holders of brokered CDs can resell them on the secondary market before maturity. Like with other fixed-income investments, the market value of these CDs fluctuates as interest rates rise and fall. If interest rates are higher, holders will see a net loss if they sell early, but then again they can end up with a net profit if rates fall.
Like traditional CDs, brokered CDs are covered by FDIC insurance up to $250,000 per account, per institution. This gives them a huge advantage over speculative investments: You’re guaranteed to get your money back. If you’d like to invest more than $250,000 and maintain FDIC insurance, you can distribute your money among different brokered CD issues sold by the same middleman, as long as you keep each deposit under the $250,000 FDIC limit per bank.
Who buys brokered CDs?
The conventional wisdom is that individual savers tend to buy traditional CDs, while bigger institutional investors tend to buy the brokered option, with the former investing smaller amounts and the latter moving large amounts of money in and out of these brokered accounts as broader markets rise and fall.
But Ken Tumin, founder and editor of DepositAccounts.com, another LendingTree-owned site, said that individual investors have more and more options for buying brokered CDs.
“For example, at Fidelity, brokered CDs can be purchased with a minimum deposit of $1,000,” Tumin said. “There are actually lots of advantages for investors to use brokered CDs instead of direct CDs, especially inside IRAs.”
Many experienced investors say that buying these CDs via online investment platforms simplifies the process of managing their CD investments, especially redeploying balances once the CDs mature. Handled properly, it can be a more convenient strategy than opening traditional CD account that are separate from your online brokerage account.
Benefits of brokered CDs
- Simpler access to a wider variety of CDs. If you choose to buy new-issue CDs directly from banks, it can be complicated to compare and evaluate offers from different institutions. If you purchase these CDs through a middleman, you can quickly and easily select CDs of different terms from a variety of issuers in different states.
- You don’t have to pay an early-withdraw fee if you sell your brokered CD early. You would have to lose some interest earnings with a traditional CD if you withdraw your funds prematurely. But the brokered option can be sold before maturity on the secondary market.
- Brokered CDs may bear higher rates. Rates on these brokered accounts are often more sensitive to ups and downs of Treasury yields than traditional CDs are. When Treasury yields are rising, the rates offered on the brokered accounts are higher than those for traditional CDs of like maturity. But there’s no guarantee.
Risks with brokered CDs
- You may lose money from selling your brokered CD prior to maturity. In an ideal situation, you want to keep your CD, brokered or traditional, until maturity. But if you have to sell your brokered CD before maturity in a rising interest environment, the demand for these CDs falls on the secondary market, and so you may have to sell your CD for less than you paid.
- Some brokered CDs are callable. This means the bank has the option to “call”, or redeem it prior to maturity at a given price, as stated in the CD contract’s terms. If rates slide after you buy your CD, then the bank will exercise the call option. And then you may have to reinvest the money at a lower rate if you want to invest in a fixed-income instrument.
- Suspiciously high rates may be a scam. Unscrupulous brokers of advertising above-market CD rates to attract people. Never fall for high rates without doing research on the broker, you can be exposed to the risk of losing money to fraud.
Brokered CDs vs. traditional CDs
All CDs are issued by banks. You purchase traditional CDs from banks directly. But the brokered accounts are purchased by brokerages in bulk from one bank and then resell them to retail investors.
Early withdrawal fee
For traditional CDs, interest is calculated on a compounded basis, while simple interest is applied to brokered CDs. If you deposit the same amount of money for the same period of time, in general, you will earn more in interest if it’s calculated on a compounded basis than if it’s simple interest.
The brokered options are more complicated and riskier than traditional CDs. The brokered accounts are more sensitive to market interest rates. You may lose money if you sell your CD before it matures because the value can slump due to rising interest rates, and longer maturities have higher interest rate risk.
You can incur early withdrawal penalties if you choose to close a traditional CD prior to maturity. In general, the longer the CD term, the bigger the early withdrawal penalty you may have to pay.
If you buy a CD through a middleman, such as a brokerage or your financial advisor, you may have to pay a fee, and there also is a transaction fee when you sell your CD. Sometimes the costs are worth it if they provide you with CDs that bear higher interest than that of traditional CDs. But that’s not always the case.
It makes sense to buy a brokered account when the interest is greater than the yield on Treasury bonds with a similar duration. In addition, unlike traditional bank CDs that pay your interest at maturity, some brokered accounts offer the flexibility of periodic payments. You can be paid monthly, quarterly, annually, or at maturity.
Making the right CD choice
Compare rates for traditional CDs and brokered CDs. In general, you go for the most competitive rates possible. But you should also factor in the minimum deposit, the payment period and potential costs associated with each CD.
If you are more of a risk taker who prefers the flexibility of closing a CD at any time, then the brokered option is for you. Likewise, if you have lots of money to invest in a deposit account and don’t want to be subject to the $250,000 FDIC-insured limit, the brokered option is the way to go.
But if you plan to invest your funds for a long term and don’t want to handle the complexity and risk associated with a brokered CD, then you will be better off with a traditional CD.