Brokered CDs vs. bank CDs: What’s the difference?
Editorial staff, J.P. Morgan Wealth Management
- Certificates of deposit (CDs) can offer relatively stable returns, especially when interest rates are favorable.
- Investors may get better rates and greater liquidity through brokered CDs; however, they are slightly more complex compared to bank CDs, and it is important to understand how they work.
- Interest on bank CDs usually compounds, providing investors with a lump sum at the end of the deposit’s term.
Certificates of deposit (CDs) are savings instruments offering a fixed interest rate to consumers willing to commit their funds for a specified period. The comparatively high interest rates of recent years have led to increased interest in CDs. This is because they offer investors a relatively low-risk option for earning competitive returns.
There are two common types of CDs: bank CDs and brokered CDs. While bank CDs and brokered CDs share many similarities, their differences are worthy of understanding. In this article, we'll explain how each one works and the key differences between the two.
What are bank CDs?
Bank CDs are savings tools offered by banks. Customers commit their funds for a set period, referred to as a CD term. In exchange, the bank typically pays a fixed rate of interest for the entire period, regardless of what happens to broader interest rates. CDs typically offer higher annual percentage yields (APYs) than standard savings accounts, though this can vary.
Bank CD terms usually range from three months to five years or longer. When the term ends, the CD matures, and the customer receives their initial deposit plus the earned interest. Banks may automatically reinvest the CD at the end of its term.
Some banks offer non-traditional CDs that may be more flexible but pay lower rates. For example, no-penalty CDs let you withdraw your money early without paying extra fees. Bump-up CDs allow you to increase the APY if interest rates rise.
What are the risks of bank CDs?
The low-risk nature of bank CDs is one of their main attractions. However, no investment is completely risk-free. Here are some of the main risks to consider with bank CDs:
- Early withdrawal penalties: Investing in bank CDs generally means tying up your money for a set period. You'll likely have to pay a penalty to access your funds before the end of the CD term.
- Opportunity risk: When you park your cash in a relatively safe investment vehicle, such as a CD, there is often a trade-off. The returns may be more stable than other investment options, but they may not match those of higher-risk investments, such as equities, especially over time.
- Fluctuations in interest rates: Interest rates change. That can be a good thing if you lock in your funds in a CD while rates are high. But if rates increase after you purchase a CD, your money may be stuck in an account that's earning less than it could be.
- Bank failure: In most cases, the Federal Deposit Insurance Corporation (FDIC) will protect your money against bank failure. However, it is important to double-check that the bank issuing the CD is an FDIC member – otherwise your funds will not be insured.
- Inflation: This can eat into your purchasing power. Hypothetically speaking, if your money is in a CD that pays a 4% APY and inflation is running at 5%, the real return on investment would be negative.
Where can you buy bank CDs?
You can buy bank CDs directly from banks. It is worth shopping around to find the best option because some CDs may pay much more than others.
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What are brokered CDs?
Consumers purchase brokered CDs from intermediaries – often brokerage firms – which buy them in bulk from banks. Though it may seem like a minor difference, this shift in ownership alters the functionality of the CD.
For example, brokered CDs may offer higher rates compared to bank CDs, depending on market conditions. Brokered CDs can also give investors more flexibility because they can be sold at any time rather than waiting for the CD’s maturity.
What are the risks of brokered CDs?
According to the U.S. Securities and Exchange Commission (SEC), brokered CDs can be more complex and carry greater risks compared to bank CDs. As such, it is important to buy from a reliable broker, such as an SEC-registered brokerage firm. Be sure to check the terms carefully; some but not all brokered CDs may be callable, which can affect your investment strategy. This means that the broker can "call" – essentially close – your CD before the end of its term. For example, if interest rates fall, the broker could call the CD rather than continuing to pay a higher-than-market rate. It would then repay the investor their deposited cash plus interest accrued to that point. This is also notably a one-way street: investors themselves cannot close a callable CD early.
To understand the other specific risks of brokered CDs, it's useful to grasp the concept of secondary markets. Secondary markets are places where investors can trade assets with one another rather than the issuer. The stock market is a well-known example of a secondary market. There is also a secondary market for brokered CDs.
Typically, with bank CDs, you have to pay an early withdrawal penalty to access your cash before the CD term is up. With a brokered CD, you can sell it on the secondary market instead. However, there's a risk: If interest rates have risen since you first opened your CD, the investment will be less appealing to secondary buyers. As a result, you may have to sell it at a discount or loss. Secondary CD sales may also incur fees.
Where can you buy brokered CDs?
Many top brokerages sell brokered CDs, whether newly issued CDs or secondary CDs. Be aware that some firms selling brokered CDs may charge fees, affecting your overall return, and that some sellers of brokered CDs are not professional brokerages and may be unlicensed.
Similarities between brokered CDs and bank CDs
Both brokered CDs and bank CDs share several common features. They include:
- Paying a fixed interest rate for a set amount of time: Most CDs lock in a set rate for the whole CD term, regardless of wider movements in interest rates. Both brokered CDs and bank CDs generally pay interest at regular intervals and aim to repay the initial deposit at the end of the term.
- Offering FDIC protection: Most of the banks that issue CDs are FDIC-insured, which covers up to $250,000 per depositor at an FDIC-insured bank, based on ownership category. This covers bank CDs and brokered CDs as long as the issuing bank is FDIC-insured.
- Tax implications: Interest earned on CDs is typically subject to federal income tax unless held in tax-advantaged accounts. Investors should consider the tax implications of their CD investments in their overall financial planning.
Differences between brokered CDs and bank CDs
Here are the main ways that brokered CDs and bank CDs differ:
- Brokered CDs may pay higher APYs and offer longer terms: Brokers can often secure better rates by negotiating to buy CDs in bulk, though rates may vary. Terms on brokered CDs can also be as long as 30 years.
- Brokered CDs can be sold to other investors: Brokered CDs are more liquid because they can often be sold on the secondary market. In contrast, bank CDs usually charge an early withdrawal penalty for early access.
- Interest on brokered CDs may not compound: Brokers typically pay CD interest directly into your brokerage account. Bank CDs usually benefit from compound interest, which is paid in a lump sum at the end of the term.
Brokered CDs | Bank CDs |
|---|---|
Seller | |
Sold by brokerages | Sold by banks |
Liquidity | |
Can be sold on secondary market | Comes with an early withdrawal penalty |
Accessibility | |
More complex product | Easier to understand |
APYs | |
May have slightly higher interest rates | May have slightly lower interest rates |
Terms | |
Can be up to 20 to 30 years | Typically from three months to five years |
Interest | |
Does not compound | Compounds |
FDIC | |
FDIC-protected if issuing bank is FDIC-insured | FDIC-protected if issuing bank is FDIC-insured |
The bottom line
Brokered CDs can offer higher APYs and provide investors more flexibility. However, they may not be as easy to manage as bank CDs. Plus, selling brokered CDs on the secondary market may not be so straightforward. Compare the pros and cons of brokered CDs vs. bank CDs, and read the fine print to decide which is right for you.
Frequently asked questions about brokered CDs and bank CDs
Brokered CDs issued by FDIC-insured banks offer FDIC protection, even though the brokerages themselves are not FDIC members. That said, investors should ensure the issuing bank is FDIC-insured to secure protection.
Yes, provided the bank is a member of the FDIC. FDIC insurance covers up to $250,000 per depositor at an FDIC-insured bank, within each ownership category.
You can have as many CDs as you want at one bank. In some cases, it can make sense to open multiple CDs of different lengths as part of a strategy called a CD ladder. One thing to keep in mind is that if your deposits exceed FDIC insurance limits, any amount over the limit at a single institution and in a specific ownership category may not have FDIC protection.
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Editorial staff, J.P. Morgan Wealth Management
