If you've been to your neighborhood bank lately, you've probably noticed that CD rates have already started to fall. For savers, that's bad news -- especially if you're on a fixed income and depend on your interest income to cover your living expenses.
In your search for higher rates, one place you might not think about is your brokerage account. After all, most people use their brokers to buy stocks, not CDs. But an increasing number of brokers offer brokered CDs, which may pay you more interest.
How brokered CDs work
The idea behind brokered CDs is pretty simple. In addition to providing CDs directly to their customers, some banks seek to extend their reach by offering CDs in large blocks to brokers, who then resell them to their clients. Many banks participate in the brokered CD market, ranging from well-known names like Morgan Stanley (NYSE: MS ) , Countrywide Financial (NYSE: CFC ) , and Lehman Brothers (NYSE: LEH ) to much smaller banks.
Just like bank CDs, brokered CDs are FDIC-insured up to $100,000. With the threat of potential bankruptcy hovering over brokerage firm E*Trade Financial (Nasdaq: ETFC ) , that insurance is becoming more and more important to protect your assets. Lots of brokers sell them, including Charles Schwab (Nasdaq: SCHW ) , Fidelity, and TD Ameritrade (Nasdaq: AMTD ) . From the investor's perspective, a brokered CD closely resembles a traditional bank CD, with just a few exceptions.
Having second thoughts
You're probably familiar with the penalties that banks charge for withdrawing money from your CD early. Typically, you might have to give up between three and six months' worth of interest if you close out your CD before its maturity date.
Brokered CDs work a bit differently. If you need money early, you generally have to sell your CD on the secondary market. Depending on prevailing interest rates and market conditions, there's a risk that you'll lose principal.
Waiting for the call
In addition, some brokered CDs are callable. That means the bank has the right to pay you back before the final maturity date.
The call feature is one of the most confusing things about brokered CDs. The best rates are often on callable CDs with long maturities of 10 years or more. For instance, you can buy a CD paying 6.12% interest. It's scheduled to mature in 2027, but the bank could buy it back from you as early as next year. It's easy to get confused and think that you own a one-year CD at an unheard-of rate.
In reality, though, you're taking a big risk. If rates fall, then the bank will likely call the CD, forcing you to find a replacement CD at lower rates. But if rates go up, you could be locked in for the full 20-year term.
Before you buy a brokered CD, make sure you understand all the terms and conditions that apply. In addition, check out whether making a direct investment would pay you a better rate. For instance, as of today, one bank offers investors a 5.4% rate on a six-month CD if they invest directly. On a list of brokered CDs, however, that bank is only paying 4.7% for the same CD.
Nevertheless, brokered CDs may give you a much-needed boost in your monthly income. As long as you're careful and understand what you're getting into, buying a brokered CD can open up a whole new world of higher rates.
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