Callable, step-up and no-penalty CDs: what the headline rate hides

Which of these are you?

• A callable CD offers a rate well above the plain CDs: you are being paid for an option you sold the bank. Compute yield to call before you compare the rate with anything.
• A step-up CD advertises "up to" a high rate: ignore the top step. The blended APY is the number that matters, and it shrinks if the bank calls the CD.
• You want a locked rate but might need the cash: a no-penalty CD may fit, at a lower rate. Price the free exit before paying for it.
• You already own one of these: find the first call date, the final maturity, and any step schedule in the disclosure, and run the numbers below.

How a call works and who it favors

A callable CD gives the issuing bank the right to redeem it early. The SEC describes the feature this way: the bank may end the CD after a year or some other fixed period, and the investor cannot call it. Because only the bank holds the option, the rate on a callable CD includes a premium that pays you for giving it up.

Banks use the option when it pays them. If market rates fall below your CD's rate, redeeming it and issuing new deposits at a lower rate saves the bank money, and you must reinvest at the lower rate. If market rates rise, the bank leaves the CD open and you stay locked below the market. FINRA's guidance on brokered CDs makes the same point: call features typically get exercised when the CD would trade at a premium to its call price.

The FDIC's Truth in Savings examination guidance says a bank offering a callable time account must disclose the date or circumstances under which it may redeem the account at its option. The SEC adds a warning: a federally insured one-year non-callable CD does not necessarily mature in one year. It only means the bank cannot redeem it during the first year, and the final maturity can be 15 or 20 years away.

Yield to call versus yield to maturity

Yield to maturity is the annual return if you hold the CD to its final maturity. Yield to call is the annual return if the bank redeems it on the first call date. The lower of the two is called the yield to worst, and it is the yield you can defend.

For a CD with annual interest, price per $100 of face is the sum of each payment discounted at the yield:

Price = Σ coupon ÷ (1 + y)^t + redemption ÷ (1 + y)^n

• coupon is the annual interest per $100 of face, in dollars.
• y is the yield you solve for, as a decimal.
• t counts years from 1 to n, and n is the years to the redemption date.
• redemption is $100 at maturity, or the call price on a call date.

There is no closed-form solution for y, so you solve it by trial, as a spreadsheet or a broker's screen does. This chapter uses annual interest and annual compounding for clarity. Brokered CDs often pay semiannually or monthly, so a real quote will differ slightly. Yield to maturity and yield to call are also computed at a specific price, which changes each time the CD trades.

Worked example. A hypothetical 10-year CD pays a 5.00% coupon once a year and is callable at par ($100) after two years. Three purchase prices:

Check the 102 row. Discount the year-1 coupon and the year-2 coupon plus the $100 call price at 3.941%: $5 ÷ 1.03941 = $4.81 and $105 ÷ 1.03941² = $97.19. They add to $4.81 + $97.19 = $102.00, so the price is reproduced.

Why the rows differ: a premium price has to be earned back in coupons above the call price, and an early call shortens the time you have to do it. Paying 102 for a CD the bank can redeem at 100 means a $2 premium per $100, or $2,000 on $100,000, is lost at the call, which pulls the yield from 5.00% to 3.94%. At 98 the call helps you, because the bank hands back $100 for a CD you bought at $98.

Buying at par, as with a new issue, makes both yields equal to the coupon. The gap opens when you buy in the secondary market above par. That is why the yield to worst, not the coupon, belongs in any comparison.

The reinvestment cost of being called

A call does not lose principal, but it changes how long you earn the rate. Take a hypothetical $100,000, 10-year, 5.00% callable CD with a first call after year 1, bought at par.

The falling-rate case leaves you $162,889.46 − $137,001.18 = $25,888.28 behind the hold-to-maturity figure the headline implied. The rising-rate case leaves you $196,715.14 − $162,889.46 = $33,825.67 behind what 7.00% money would have paid. You gave the bank an option that never works against it. Unless the callable CD pays clearly more than a comparable non-callable CD, and you can live with the 3.00% outcome, skip it.

For a longer treatment of the reinvestment problem, see the callable CD reinvestment guide.

Step-up CDs and the headline-versus-average trap

A step-up CD pays a rate that increases on a set schedule. Regulation DD defines a stepped-rate account as one with two or more rates that take effect in succeeding periods and are known when the account is opened (12 CFR § 1030.2). Banks advertise the top step. The APY, which Regulation DD requires, assumes each rate applies for its full period and blends the total interest over the whole term (12 CFR Part 1030, Appendix A).

Appendix A's formula is APY = 100 × [(1 + Interest ÷ Principal)^(365 ÷ Days in term) − 1]. With annual steps the same result is the geometric average of the annual growth factors.

Worked example. A hypothetical 5-year step-up CD pays 3.00%, 3.50%, 4.00%, 4.50% and 5.50% in years 1 through 5. Compare it with a hypothetical fixed 4.00% five-year CD, on $50,000.

1. Growth factor = 1.03 × 1.035 × 1.04 × 1.045 × 1.055 = 1.222305.
2. Blended APY = 1.222305^(1/5) − 1 = 4.096%. The "up to 5.50%" is 1.4 points higher than the blended APY.
3. The simple average of the five rates is 4.10%, close but not identical, because interest compounds.
4. Held to maturity: $50,000 × 1.222305 = $61,115.26. The fixed 4.00% CD ends at $50,000 × 1.04^5 = $60,832.65. The step-up finishes $282.62 ahead.

That $282.62 edge exists only if the CD is never called. Step-up CDs are often callable, and a bank has a reason to call when the coming steps would pay above market rates, which is exactly when the step-up is about to become valuable.

5. Suppose the bank calls after year 3, before the 4.50% and 5.50% years. You have $50,000 × 1.03 × 1.035 × 1.04 = $55,434.60, an annualized 3.499%. The fixed CD, in the same three years, is worth $50,000 × 1.04^3 = $56,243.20. The step-up trails by $808.60.

FINRA warns that on a step-rate brokered CD the initial rate cannot be used to calculate yield to maturity, and that the step rate may be below or above prevailing market rates at that time. Its 2002 guidance also warns that long-term CDs combining step-down rates and call provisions are less favorable to investors than traditional CDs. FINRA's notice dates from 2002, but the arithmetic above is unchanged.

Ask three questions of any step-up: what is the blended APY, is it callable, and what would it earn if called on the first date. The step-up wins only when it survives to the last step.

No-penalty CDs: what the free exit costs and when it pays

A no-penalty CD lets you withdraw your balance and interest before maturity without a penalty, after a short lockout. The lockout comes from the Regulation D definition of a time deposit: the depositor may not withdraw within six days of deposit unless an early withdrawal penalty of at least seven days' simple interest applies to amounts withdrawn in those six days (12 CFR § 204.2(c)(1)). Footnote 1 to 12 CFR § 204.2(c)(1)(i) permits penalty-free early withdrawal on the death of an owner or a court's finding of legal incompetence.

In practice, banks build the product around that window. Ally's No Penalty CD, as an example, has an 11-month term and lets you withdraw the full balance and interest at any time after the first six days following funding. The APY is fixed for the term. Other banks differ on partial withdrawals, minimums and terms, so read the account agreement.

The cost is a lower rate than a comparable standard CD. That lower rate is the price of an option. The question is whether you will exercise it.

Worked example (hypothetical rates). $50,000 for 11 months. A no-penalty CD pays 3.90% APY and a standard CD pays 4.20% APY.

1. Standard CD, held to the end: $50,000 × 1.042^(11/12) = $51,921.68.
2. No-penalty CD, held to the end: $50,000 × 1.039^(11/12) = $51,784.64.
3. The unused option costs about $137 (the exact difference is $137.05).
4. Now exercise it at month 6. The no-penalty balance is $50,000 × 1.039^(6/12) = $50,965.67.
5. To finish level with the standard CD, that balance must earn x over the remaining 5 months: $50,965.67 × (1 + x)^(5/12) = $51,921.68, so x = 4.56% APY.

So the exit pays only if you can move the money to a rate near 4.56%, which is 0.66 points above the no-penalty rate you were earning, or if the alternative is a need for cash rather than a rate. Treat the free exit as insurance for a cash need and for a large enough rate rise. It is a hedge with a price.

For a standard CD, the bank-direct alternative is a penalty, and chapter 3 computes the break-even replacement APY for that case.

If you like the idea of a rate that can be raised, read about bump-up and add-on CDs. For where to find no-penalty offers, see the best no-penalty CDs list, and for the comparison with a floating-rate savings account see no-penalty CD vs high-yield savings.

Brokered versions and the ladder

All three features appear in brokered CDs, where a sale replaces the penalty. A callable, step-up brokered CD combines the reinvestment risk of the call with the price risk of a sale.

When you run a ladder, treat each callable rung as if it ends on its first call date. Chapter 8 covers what to do at each maturity.

The decision rule

• Callable: compute yield to worst. Take it only if you can accept the CD ending on the first call date and staying open to final maturity. Otherwise a non-callable CD at a slightly lower rate is the plan you can rely on.
• Step-up: convert to blended APY and check whether it is callable. Compare that APY with a fixed CD of the same term.
• No-penalty: price the lower rate against your chance of using the exit. If you are sure you will not touch the money, take the higher standard rate. If a cash need or a meaningful rise in rates is realistic, the exit has value.