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Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Brokered Certificate of Deposit

What it is:

A brokered certificate of deposit (a brokered CD) is a CD sold by a brokerage firm.

How it works (Example):

A CD is a time deposit with a bank or financial institution. The investor agrees to leave the deposit with the institution for a fixed amount of time (usually six months, 1 year, or 5 years) in return for a specified interest rate. When the CD matures, the investor receives his original principal plus the accrued interest. Although an investor can redeem his CD before it matures, doing so usually triggers early withdrawal penalties that vary by institution.

Purchasing a CD is as easy as going to a local bank, but brokerage firms also sell CDs. These brokered CDs are actually pieces of larger CDs. The broker simply compiles the deposits of several investors and buys one, large CD with the money. One advantage of doing this is that investors might be able to benefit from the broker's access to information from institutions across the country and its ability to negotiate special higher interest rates. Many brokers do not charge investors a fee to invest in these brokered CDs. Instead, they usually receive a commission from the issuer.

There are often no early withdrawal penalties for brokered CDs, but if an investor does in fact want to withdraw his or her money early, the broker or investor must try to find another buyer for that portion of the CD (this is why there is a secondary market for brokered CDs). There is some risk associated with this, because if interest rates have risen, there may be little demand (likewise, if rates have fallen, the investor might be able to profit from the situation). This can often result in a loss to the initial investor if interest rates have fallen since the initial investment.

It is important that investors work with a reputable brokerage firm, because there are no licensing or certification processes to become a deposit broker, nor does the Federal Depository Insurance Corporation (FDIC) examine deposit brokers. It is also important to determine whether the CD is issued by an FDIC-insured bank and whether that issuer is one where the investor already has deposits, because this could limit the FDIC insurance available to the investor. Remember, the Federal Depository Insurance Corporation and the National Credit Union Administration insure CDs for up to $250,000, but this coverage is for the total of an investor’s deposits at any one institution. Thus the investor is not fully insured, for example, if he or she has $150,000 in a checking account and then purchases a $150,000 CD from the same institution.

Investors should also be sure get a copy of the actual title on the CD so that they have proof that the broker is acting as an agent for the investor and the other depositors on the CD. This helps preserve each investor's entitlement to $250,000 of FDIC coverage on the CD. Otherwise, the FDIC may consider the broker the owner of the CD and only insure $250,000 of the total principal.

This is one reason why the secondary market for brokered CDs can be a tough place. If the broker is considered the owner of the CD, then any amounts over $250,000 are essentially uninsured and the creditworthiness of the issuer becomes paramount.

Why it Matters:

In general, CDs offer higher returns than savings accounts and traditional money market accounts, which are more liquid. This makes them excellent short- to medium-term investments (typically from three months to seven years) for risk-averse investors, especially those who want to be sure there is a specific amount of money available at a specific time.

However, there are some disadvantages. An important one is that a CD is locked in at a specific rate for what could be a long time, which may result in missed opportunity if rates increase. And unlike Treasury notes, the interest on CDs is not exempt from state and local taxes. In fact, interest on CDs is taxable as ordinary income at the federal, state, and local level in the year it is earned, even if the investor doesn’t withdraw the interest. For this reason, many income investors choose to hold CDs in their IRAs or other tax-advantaged accounts.

Clearly, brokered CDs can be more complicated and riskier than regular CDs purchased right from a bank. Brokered CD rates and terms vary widely, as do the deals and terms offered by their brokerage firms, so it is always a good idea to shop around. Investors should check out the value of a similar brokered CDs on the secondary market before offering the broker a price, and they should also consider whether a CD is appropriate for their financial goals, objectives, and risk tolerance.

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