What is a callable CD? How they work, risks, and strategies

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Callable CDs work much like traditional CDs but with a twist — the issuing bank retains the right to "call" or redeem them before maturity. Callable CDs typically offer higher interest rates in exchange for this added flexibility. 

Callable CDs can be an attractive way to boost returns without venturing too far out on the risk spectrum. However, it’s essential to understand the potential benefits and the inherent risks before adding them to your portfolio.

What are callable CDs?

At their core, callable CDs work much like regular CDs. You agree to deposit your money for a set term — ranging from a few months to several years — in exchange for a fixed rate. Your money is locked in for the entire term, and you'll face penalties for early withdrawals.

The key difference with callable CDs lies in the "call" provision. This gives the issuing bank the right (but not the obligation) to redeem the CD before it reaches maturity. Banks are most likely to exercise this option if market interest rates fall below the rate they're paying on the CD.

For example, let's say you invest in a 5-year callable CD paying 5% interest. If rates drop to 3% a couple of years later, the bank may call your CD, returning your principal and any accrued interest up to that point. They can then turn around and issue new CDs at the lower 3% rate, saving themselves money.

As an investor, this leaves you in the position of reinvesting your money at the new, lower interest rate. You miss out on the higher returns you anticipated for the full five-year term.

Callable CDs offer several advantages in an uncertain interest rate environment: 

• For banks: Callable CDs function as insurance for banks in a falling-rate environment. If interest rates drop, the bank can recall the CD and reissue it at a lower rate, saving them money.
• For investors: To compensate investors for taking on this added risk, callable CDs generally pay a higher rate than traditional CDs. 

When interest rates fluctuate, callable CDs can be attractive to both investors and banks. Banks get some protection from potential losses, and investors have the chance to earn higher returns. 

Benefits of investing in callable CDs

The most appealing aspect of callable CDs is that their rates are often higher than regular CDs. How much higher? It varies, but a difference of one percentage point or more is not uncommon.

Higher interest rates 

For example, if standard 5-year CDs are paying 3%, you might be able to find a callable CD of the same term offering 4% or 4.5%. Over time, that can translate to much more interest, especially on larger deposits. 

Let's say you invest $10,000 in a traditional 1-year CD with a 3% APY to a 5-year callable CD with a 4.5% APY. The traditional CD would earn $300 in interest, while the callable CD would earn $450.

This difference of $150 in interest earned shows the potential that callable CDs offer. Here’s a look at how that $10,000 investment would compare invested in a traditional CD versus a callable CD across different term lengths.  

This is assuming that the issuer doesn’t call your CD before the term ends. 

Potential for long-term investment 

Another benefit of callable CDs is the potential for long-term investment, as some offer terms of up to 10 years or more.  

Callable CDs can provide a stable and predictable income stream for those with a long-term horizon if interest rates remain favorable and the CDs are not called early.  

Like traditional CDs, callable CDs are FDIC-insured up to $250,000 per person per account. Even if the issuing bank fails, you can get your money back up to the insured limit. This government backing makes CDs one of the safest investment options around. 

Risks of investing in callable CDs 

Of course, no investment is without risk, and callable CDs have a few important ones to be aware of.

Interest rate risk 

Interest rate risk is one of the most significant risks associated with callable CDs. If rates drop, there's a good chance your CD will get called early. This forces you to reinvest at a lower yield that may not match your long-term goals. 

For example, let’s say you picked that 5-year callable CD with a 4.5% APY (over the traditional CD earning 3% APY), and interest rates drop to 2% after the first year. If your CD is called, you must reinvest their principal at the lower 2% rate for the remaining years. This would result in a lower overall return than if you had invested in the traditional CD.

Liquidity risk

Another risk to consider when investing in callable CDs is liquidity risk. Like traditional CDs, callable CDs may impose early withdrawal penalties if you need to access your funds before the term ends. These penalties can be high, ranging from several months' to a year's worth of interest, depending on the CD's term. 

What to consider before investing in a callable CD

Before investing in a callable CD, assess your risk tolerance and investment horizon. While the higher rates offered by callable CDs can be tempting, you should be comfortable with the potential of your CD getting called. 

Not all callable CDs are created equal, and you should review the specific terms of each option. Some key factors to consider include the CD's term, interest rate, call dates, and any restrictions on the issuer's ability to call the CD.

You should also understand the tax implications of callable CDs. Interest earned on callable CDs is generally taxable as ordinary income in the year it's received. Your earnings may be subject to federal, state, and local taxes. 

Alternatives to callable CDs 

While callable CDs can be a solid option, they're not the only option. There are several options that offer similar benefits without some of the drawbacks of callable CDs. Here are a few alternatives worth considering:

• Traditional CDs are the most direct alternative to callable CDs. They provide the same security and safety without the risk of an early call. The trade-off is that they often have lower rates than comparable callable CDs. Traditional CDs can be a smart choice for those who want stability and predictability over yield.
• High-yield savings accounts often offer rates that rival or even exceed certain CDs. The main advantage of high-yield accounts is that they provide liquidity, allowing you to withdraw your money at any time without penalty. This makes them ideal for short-term savings goals or emergency funds.
• Bond funds pool money from many investors to buy a diversified portfolio of bonds. These investments provide greater liquidity than CDs, as you can sell your shares at any time without penalty (though you may face a loss if interest rates have risen and bond prices have fallen). Remember that bond funds are subject to interest rate risk, like CDs, but they also face credit risk (the possibility of bond issuers defaulting).

Strategies for investing in callable CDs 

Despite these risks, callable CDs can be useful in a well-rounded portfolio. The key is to use strategies to mitigate the risks and maximize the potential benefits. 

Laddering strategy 

One approach is the laddering strategy, which involves investing in multiple callable CDs with different term lengths. By staggering the maturity dates, investors can minimize the impact of interest rate fluctuations and reinvestment risk. 

If one CD is called early, the investor still has other CDs on their ladder that can continue earning interest at the original rates. 

For example, an investor could create a laddered portfolio of callable CDs by investing $20,000 in the following manner: 

• $5,000 in a 1-year callable CD with a 3% APY 
• $5,000 in a 2-year callable CD with a 3.5% APY 
• $5,000 in a 3-year callable CD with a 4% APY 
• $5,000 in a 4-year callable CD with a 4.5% APY 

By diversifying across different term lengths, you can benefit from higher interest rates on the longer-term CDs while maintaining some flexibility to reinvest if the shorter-term CDs are called early.

Adding callable CDs to your investment portfolio

Another strategy to lower risk and boost returns is incorporating callable CDs into your investment portfolio. By blending callable CDs with other fixed-income investments, such as traditional CDs, bonds, and money market funds, investors can balance risk and return across different asset classes. 

By spreading your money across multiple asset classes, you can cushion the impact of an early call on any position. You'll also have more reinvestment options if rates do drop sharply. 

The bottom line 

Callable CDs can be an attractive option if you’re looking for higher interest rates and the potential for long-term growth. But as with any investment, doing your homework before jumping in is crucial. 

Carefully evaluate the specific terms of any callable CD before committing your money. Pay close attention to the yields, call dates, and early withdrawal penalties.  

Most importantly, consider how callable CDs fit into your long-term investment plan. Callable CDs can be a valuable tool for navigating changing markets when used smartly.  

Editorial disclosure: Opinions expressed are author's alone, not those of any bank, credit card issuer, or other entity. This content has not been reviewed, approved, or otherwise endorsed by any of the entities included in the post.