Tough Choice: Bank CDs vs. Brokered CDs

Choosing between a bank or brokerage certificate of deposit sounds like a no-brainer. Pick the one with the best rate, right?

Before choosing, though, you should know the risks and rewards of buying and holding either of them. There are some big differences that can ding returns. Bank CDs that you can buy at your your local bank are usually traditional certificates of deposit. But brokered CDs, which are bank CDs bought by brokers and then resold, may have stiff fees and special features that can slash returns. In addition, brokerage CDs may not be as competitive and risk-free as you think.

"Brokered CDs used to pay higher rates," says Robert Laura, president of Synergos Financial Group in Howell, Mich. Now they're flat.

On the plus side, brokered CDs offer diversification among banks in different states. That makes it easier to ladder CDs, which is investing in several CDs with differing maturities, says Herb Hopwood, president of Hopwood Financial Services in Great Falls, Va.

Hopwood says when people buy lots of different CDs, they may forget when they mature. With brokered CDs, purchases are usually listed on a brokerage statement, notifying you when maturity dates are approaching.

For investors parking more than $1 million, brokered CDs that can be diversified among many banks also make sense. That's because the insurance limit by the Federal Deposit Insurance Corp. is $250,000 per depositor, per insured bank, giving you more protection. You can easily spread out your risk among different bank CDs nationwide.

Given these wrinkles, the key to buying a CD is knowing what you're buying. Here are some questions that can get you started.

How much are fees? Fees can diminish returns, especially during low-interest times like these. And brokerage fees can run as high as 50 basis points per CD, Laura says. However, banks usually don't charge fees on their CDs.

Where can you get the highest rates? If you have many accounts at one bank or a high balance of more than $100,000, you may be able to negotiate higher bank CD rates. Online banks are the exception; they usually don't negotiate CD rates, Laura says.

On the downside, regional bank rates can vary dramatically from national ones. But don't worry. You can check for higher CD yields at nationwide online banks.

What's the early withdrawal policy? Banks typically charge an early-withdrawal penalty of 90 days' worth of interest, but brokered CDs are different, Laura says. If you want to exit your investment, you must sell your CD on a secondary market, where CDs are sold by brokers and prices are driven by investor demand. That means you could lose principal, especially when interest rates rise and CD demand slumps.

Who is the issuer? Brokered CDs typically are bought in bulk from one bank and then sliced into pieces. Sometimes these CDs are lower quality, meaning they may have lower safety ratings but offer higher yields. "They're usually offered by institutions that need to raise funds," Hopwood says. "They're not always the strongest."

Take Bank of Puerto Rico, which failed last year. Its CDs were sold by brokers. "Brokers say, 'Here's the CD,'" Laura says. "But they may not lay out the bank's financials."

That means it's up to you to identify and vet the issuer, not the broker. And if that bank fails, getting your money from a broker usually takes more time than getting it from a bank would.

"The process can take 60 to 90 days with a brokered CD," Laura says. That's time when your money isn't being invested and earning interest. Conversely, bank depositors get their money faster, usually seven to 10 days.

Also, a broker may unknowingly put your money in a bank CD where you already have deposits. Then your deposit exceeds the $250,000 FDIC limit, warns the Securities and Exchange Commission.

On the flip side, local institutions that issue bank CDs are easier to vet and to follow. "But with a CD from a bank in Utah, you may not know it failed until it's actually closed," Laura says.

How complex is the CD? Usually, brokered CDs are more complex and risky than bank CDs. For example, many brokered CDs are callable. So, there's a window of time, perhaps a year, when they can be yanked before they mature. That means locking in a good interest rate for a long time is harder to do, according to the SEC.

Bank CDs are rarely callable. "That's the main benefit," Laura says.