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Brokered CDs: How They Work

min read

man-viewing-charts-on-computerWhile people generally buy certificates of deposit (CDs) directly from a bank, CDs may also be offered by a third-party who negotiates with banks.

These are known as brokered CDs, and you should know the potential risks and benefits of brokered CDs before you invest in one.

What is a Brokered CD?

A brokered CD is one where a third-party broker negotiates CD rates and terms with banks on behalf of the customer.

Rather than shopping for CDs yourself and contacting a bank directly to sign up for one, a broker does the legwork for you. These brokers may know the market well and have a network of banking contacts. This may allow them to quickly identify the best CD rates for your needs.

The broker's role may involve more than just researching CD rates for you. If the broker does a lot of CD business, it may have the buying power to negotiate special rates for its clients. It can also construct a portfolio of multiple CDs for you across different banks, without your having to deal with multiple banks.

FDIC Insurance and Brokered CDs

CDs held at banks are covered by FDIC insurance up to the full limit, which is $250,000 per depositor at any one bank. Does the same protection apply to brokered CDs?

Under the right circumstances, a brokered CD can be covered by FDIC insurance just the same way as if you had opened the CD directly at the bank. However, you should make sure that the CD you are investing in is issued by an FDIC-insured bank.

Make sure the account is opened in a way that reflects the broker's role as an agent or custodian of the account. Otherwise, if the broker is listed as the owner of the account, the FDIC insurance may not be passed through to the individual clients of the broker. This could be a problem if the combined value of client accounts exceed the $250,000 insurance limit.

Potential Benefits of Brokered CDs

Since CDs are readily available from many different banks, why would you involve a third party like a broker?

Brokered CDs are touted as having the following potential benefits:

1. The possibility a broker could find higher rates

If you go to a bank individually, it is unlikely you will have much in the way of bargaining power with that bank. After all, you would be one of thousands of customers.

However, a broker who can come to the bank with business from several clients may represent a large enough volume of business to negotiate special terms with the bank. These special terms may include a preferred interest rate and/or a lower early-withdrawal penalty.

2. Additional FDIC insurance while dealing with one source

If you have deposits that would exceed the $250,000 FDIC insurance limit, you can keep your deposits insured if you spread them out among multiple banks.

A broker could manage that for you so you could get the insurance benefit of depositing money at different banks without having to deal with each of these financial institutions separately.

3. A chance to optimize a CD ladder without dealing with multiple banks

A CD ladder entails having a series of different CDs that mature at different times.

While it's natural to put together a CD ladder by investing in a range of different CDs at the same bank, that is not always the best arrangement.

It may turn out that the bank offering the best 1-year CD rate is not the same as the bank with the best 5-year rate. Having a broker manage your CD ladder for you is one way to get the best rate for each type of CD without the trouble of having to deal with multiple banks.

4. A secondary market could create added liquidity

Ordinarily, when you put money into a CD, your money is locked in for the term of the CD. If you want to get your money out early, you may be required to pay an early-withdrawal penalty. However, a broker who is helping multiple clients invest in CDs might be able to find a buyer for your CD, thereby allowing you to cash it in before its term is up.

>> Check if your CD is losing value to inflation. Use our CD inflation calculator

Potential Risks of Brokered CDs

While there are potential benefits to brokered CDs, there are also some potential risks:

1. CD issuers may not be FDIC-insured

Even though you'd be dealing with a broker rather than directly with the CD's issuer, it is important that you know which financial institutions are issuing any CDs in which you invest. That way you can check that those institutions are FDIC-participating banks and thus covered by FDIC insurance.

2. Overlapping holdings could exceed the FDIC limit

Another reason it is important to know the issuers of your CDs is so you can make sure you are not inadvertently exceeding the FDIC insurance limit.

For example, if you have a $100,000 savings account at a bank and a broker happens to put you into a $200,000 CD at the same bank, the combination of the two accounts would exceed the $250,000 FDIC limit.

3. Limited liquidity if you want to sell

While it is theoretically possible that a broker could find a buyer for your CD if you want to get out early, this is by no means a sure thing. The broker might not be able to find any demand for that particular type of CD at the exact time you want to sell it, so the potential benefit of secondary market liquidity could be limited.

4. Loss of principal if you sell early

Even if the broker is able to find a buyer for your CD if you want to get out of it early, that buyer may not be willing to pay full price for it. In particular, the same circumstances that make you want to get out of a CD early, such as a rise in interest rates, might reduce the attractiveness of that CD to potential buyers.

The principal value of CDs is guaranteed if you hold them till maturity, but it is possible to lose money on a CD if you sell out of it early.

5. Third-party risk

Make the sure broker you deal with is reputable and listed as an agent or custodian rather than the owner of the CD. Remember, the FDIC regulates banks but not brokers, so it's up to you to check out the bona fides of any broker with whom you deal.

Alternatives to Brokered CDs

If higher rates and the potential for greater liquidity are what appeals to you about brokered CDs, you can also consider some alternative ways to get those benefits:

Shop online for best rates

The ability to shop for rates and open an account online increases the number of banks to which you have access and the ease of getting information on their rates.

You might find that you can do about as well doing your own shopping for a CD as you could with a broker finding one for you.

CD laddering

If you put together a ladder of CDs that mature at different times, you can get the rate benefit of a long-term CD while still having money become available at regular intervals. This might be a more reliable source of liquidity than counting on a broker to be able to sell you out of a long-term CD early.

Look for low early-withdrawal penalties

If you are concerned that you might want to get out of your CD early, you should be shopping for a CD with a fairly low early-withdrawal penalty. As an alternative to counting on being able to sell out of a brokered CD early, a mild early-withdrawal penalty - or even a no-penalty CD - could at least lessen the impact of needing to cash in before the CD matures.

Brokered CDs are not necessarily any better or worse than working directly with a bank. They are an alternative you can consider by comparing whether a brokered CD could produce a better yield than you could get on your own.

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