May
20
2024
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A Beginner’s Guide to Investing in CDs

By | Growing Wealth, invest, Investing | Comments Off on A Beginner’s Guide to Investing in CDs

A certificate of deposit (or CD) has many of the same low-risk benefits as a savings account, but a CD holds your money for a fixed time period in exchange for a higher rate of interest than the standard savings account.

You may be familiar with CDs as part of your savings strategy (say, keeping money secure and earning interest until you are ready to buy a house), but they can also be used as a part of a portfolio’s cash allocation. CDs generally pay a higher interest rate than you can get with other cash accounts. Owing to their lower risk profile and modest but steady returns, allocating part of your portfolio to CDs can offer diversification that may help lower your risk exposure in other areas.

Here’s a closer look at the ins and outs of investing in CDs.

Key Points

•   Certificates of deposit (CDs) offer higher interest rates than regular savings accounts by locking funds for a fixed period.

•   CDs are available through banks, credit unions, and brokerages, with varying terms and minimum deposits.

•   Early withdrawal from a CD incurs penalties, typically costing several months’ interest.

•   Investment strategies like CD laddering, barbells, and bullets help manage liquidity and returns.

•   CDs are insured up to $250,000, providing a safe investment option with predictable returns.

How to Buy CDs

Investors can buy CDs at many, if not most financial institutions, such as banks, credit unions, or brokerages. Not all institutions might offer CDs, and others may have limited options, but generally, if you’re looking to buy CDs, you might want to start at your bank, where you might hold a savings account.

Again, a certificate of deposit is similar to a savings account in that you can stash your money for a long period of time, but CDs possess some distinct features you need to understand in order to gauge whether they’re a good fit with your plan. Here are some aspects of CDs to keep in mind.

1. A Fixed Deposit for a Set Time Period

Investors purchase a CD for a fixed amount of money: e.g., $1,000, $5,000, or more. Some banks have a required minimum deposit; others don’t. Generally, you cannot increase the amount of your savings (although you can always buy another CD). Some banks offer jumbo CDs, which might require a minimum $100,000 deposit.

Unlike a savings account, which is open-ended (and allows you to access your cash at any time), you typically purchase a CD for a set period of time during which you can’t withdraw the funds without a penalty. Typical CD terms can vary from one month to five years, so check with the institution that issues the CD.

2. Guaranteed Interest Rates and Insurance

Because investing in CDs is less liquid than a savings account, the interest rate tends to be higher. CD rates are quoted as an annual percentage yield (APY). The APY is how much the account will earn in one year, including compound interest. Banks generally compound interest daily or monthly.

When the period is up, also known as the CD maturity date, the CD holder can receive the original investment, plus any interest earned. The interest rate can vary considerably, depending on the institution. Also, longer-term CDs tend to offer higher rates than shorter-term ones.

The money in a CD is protected by the same federal insurance (FDIC) that covers all deposit products, whether at a bank, credit union, or other institution.

3. Early Withdrawal Penalties

CDs can offer higher yields because customers are promising the bank that they will deposit their money for a set period of time. As a result, investing in CDs means the money is usually locked up until it reaches its maturity date. Withdrawing the money before the CD matures may trigger a penalty, which could effectively eliminate any interest rate gains.

The penalty for an early withdrawal on a CD is often stated in terms of interest: e.g. you would owe 60 days’ worth of interest, 150 days’ worth of interest, and so on. The penalty is usually charged according to the simple interest rate on your account, not the compound interest you might have earned over time.

Before purchasing a CD, it’s best to look at its disclosure statement, which should tell you the interest rate, how often interest is paid, the maturity date of the CD, and any early withdrawal penalties.

Note: There are penalty-free or no penalty CDs. These allow you to withdraw funds before the maturity date without a fee, but they typically have lower interest rates than other CDs.

4. Terms Vary Widely

It’s important to shop around for the best CD rates and terms. Brick-and-mortar banks may pay lower rates, while online banks and credit unions may pay higher rates. Because the interest rates on CDs are based on the federal funds rate, similar to mortgages and other financial products, it’s also a good idea to see whether the Federal Reserve is about to raise or lower interest rates before deciding whether it’s a good time to invest in CDs.

CD Investing Strategies

CDs can be incorporated as part of your financial plan in various ways. They can act as short-term savings vehicles — a way to secure your money for a down payment or a large purchase within five years, say. Or they can be part of a longer-term strategy. Here are some examples.

CD Ladder

A CD ladder uses a combination of shorter-term and longer-term CDs to maximize different rates of return and deliver several years of steady income.

Hypothetically, say you want to invest $10,000 over a 10-year period. You could create a CD ladder by purchasing five CDs of different maturities all at once, and reinvesting them as follows:

•   Deposit $2,000 in a 1-year CD. When that CD matures, roll over the money plus interest into a 5-year CD.

•   Deposit $2,000 in a 2-year CD. When that CD matures, again roll over those funds into another 5-year CD.

•   Do the same for a 3-year, 4-year, and 5-year CD. As each one matures, you roll over the funds, plus any accumulated interest, into a 5-year CD.

The result will be five different CDs that mature one year apart, allowing you to withdraw your funds plus interest. This strategy ensures some diversification of interest rates, so your money isn’t locked into a flat rate for the full 10 years. It can be reassuring to know that, if you need access to cash, you can expect one of the CDs to be on the verge of maturing at regular intervals.

CD Barbell

The CD barbell is like a CD ladder, but without buying any mid-length CDs: Here you invest a certain amount in a short-term CD (say, a 1-year CD), and the rest in a 5-year CD as a way to hedge your bets.

The barbell strategy allows you to take advantage of both short- and long-term rates. When the short-term CD matures, you can either reinvest at the short-term rate, if that makes sense, or shift the money over to a longer-term CD.

CD Bullet

Instead of buying a few CDs of different maturities at the same time, the bullet strategy allows you to invest different amounts at different times, as a way of saving for a specific goal like a down payment.

This strategy could allow you to invest one amount in a CD to start, save up more for a year or two and buy another CD that matures at the same time as the first, and so on. Then you have, say, three CDs that mature at the same time, with interest, allowing you to withdraw the lump sum from each one for your goal.

For example:

•   You could invest $5,000 in a 5-year CD today.

•   Then, in two years, invest $3,000 in a 3-year CD.

•   Last, save up money for another two years and buy a $2,000 1-year CD.

•   All three CDs mature at the same time, and you can withdraw all the money, plus compound interest.

Benefits of Investing in CDs

Investing in CDs can offer some investors specific benefits.

Peace of Mind

CDs are generally considered one of the safer options for investors. Like traditional savings accounts or high-yield savings accounts, CDs are insured for up to $250,000 per depositor, per account ownership category, per insured institution, when they are purchased through an FDIC-insured bank or an NCUA-insured credit union. In the very rare instance of the CD-issuing bank failing, your deposits would be covered up to $250,000.

Predictability

CD interest rates are usually fixed and will deliver a predictable yield at the end of their term. The same is not necessarily true of traditional savings accounts, which may lower the amount they pay if interest rates drop. The ability to calculate exactly how much you’ll be paid at the end of the CD’s term makes it easier to know how that CD will fit into a financial plan.

A Variety of Options

Thousands of banks and credit unions across the country offer a diverse selection of CDs, which come with many interest rate options and with maturity lengths from a month to a decade.

There also may be different styles of CDs to choose from (you’ll learn about bump-up and add-on CDs in a moment). But, as always, be sure to check the terms.

Drawbacks of Investing in CDs

Of course, like any other investment, CDs can come with their share of potential downsides.

Illiquidity

One of the main drawbacks of a CD is that most of them are relatively illiquid, meaning you can’t access the funds whenever you like. An investor’s money is tied up until the maturity date, and early withdrawals may trigger penalties in the form of lost interest payments or, in some cases, lost principal.

Though there are some CDs that offer penalty-free withdrawals, investors must often accept lower interest rates in trade.

When choosing a CD, it’s best to carefully consider a maturity date you know you will be able to meet. An emergency fund can help you avoid the temptation to tap CD investments when the unexpected happens.

Inflation Risk

Despite the fact that CDs tend to offer higher returns than traditional savings accounts, they can still be subject to the same inflation risk. When inflation is high, CD returns may be unable to outpace it. That means the money sitting in the CD may lose purchasing power before reaching maturity.

Taxes

When investors withdraw money from CDs after the maturity date, they pay no taxes on the principal withdrawn, but the money earned is taxable on state and federal levels as interest income.

The taxes will reduce the amount of money a CD investor will actually get to take home. It’s a good idea to carefully consider taxes when shopping for a CD and deciding on an APY.

Opportunity Cost

Money that’s tied up in a CD can’t be put to work anywhere else — a problem known as opportunity cost. CD interest rates may be higher than some other bank products, but stocks, bonds, and other investments may offer much higher returns. That said, higher returns are often associated with higher risk.

CD investors may be opting to avoid risk or using the accounts to diversify a portfolio that already holds a mix of stocks and bonds.

Types of CDs to Invest In

Above, you learned about the basic structure of a traditional CD, but there are a few other types that may offer features that are more desirable. In some cases, these may come with tradeoffs or additional risk factors, so be sure to weigh the pros and cons and terms of each.

1. Liquid CDs

If you’d prefer a CD that allows you to access your savings before the maturity date without paying a penalty, a liquid CD may offer a solution. These CDs don’t charge a penalty for early withdrawals, but they may offer lower interest rates as a result.

2. Bump-up CDs

Some investors dislike the idea of locking up their cash at a fixed rate, when in theory rates could rise, and you’d lose out on the higher rate of return. A bump-up CD may help address that concern by allowing you a chance to “bump up” to a higher rate.

3. Add-on CDs

If you don’t have the specific amount required to open a CD, another option could be to open an add-on CD, which allows you to make additional deposits.

4. Variable Rate CDs

Like a variable rate loan, a variable rate CD doesn’t pay a fixed interest rate. Having a variable rate may give you higher or lower rates at some points, but the point is that the rate isn’t guaranteed, so you have to be willing to take your chances.

5. Uninsured CDs

If you’re willing to forgo federal insurance on your deposits, you might be able to get a higher interest rate.

In all cases, be sure to check the terms of the CD you’re about to buy, in case there are restrictions or caveats that might make a certain CD less desirable. For example, there are some CDs offered by foreign banks, but denominated in US dollars, which may offer competitive rates but they are not federally insured.

6. Brokered CDs

A brokered CD is a lot like a traditional CD but is purchased through a broker, typically using a brokerage account. This setup can provide access to a wide range of CDs from different financial institutions.

It is also possible to trade brokered CDs on the secondary market. Finding a buyer may be difficult, however, which could mean accepting a lower price for the sale. Brokered CDs may come with additional fees.

The Takeaway

Although CDs are sometimes dismissed as simple savings vehicles, in fact investing in CDs can offer a steady if modest rate of return, and some peace of mind — factors that may appeal to some investors, especially over time. It’s also possible to use different strategies like a CD ladder to create an income stream or maximize different interest rates over time.

If, however, the idea of locking up your money for a set period of time doesn’t suit your needs, you might consider a high-yield checking and savings account instead.

Interested in opening an online bank account? When you sign up for a SoFi Checking and Savings account with direct deposit, you’ll get a competitive annual percentage yield (APY), pay zero account fees, and enjoy an array of rewards, such as access to the Allpoint Network of 55,000+ fee-free ATMs globally. Qualifying accounts can even access their paycheck up to two days early.


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🛈 While SoFi does not offer Certificates of Deposit (CDs), we do offer alternative savings vehicles such as high-yield savings accounts.

FAQ

Where do you go to invest in CDs?

Investors can purchase CDs at many financial institutions, such as banks, credit unions, or brokerages, although not all institutions will offer them.

How much does a $10,000 CD make in a year?

The ultimate yield on a $10,000 CD in a year will depend on the associated interest rate and compounding frequency, which can vary. But assuming the interest rate is 3.00%, an investor could earn $300 after one year if compounded annually.

Are CDs considered low-risk?

CDs are generally considered to be lower-risk investments, especially compared to assets like stocks.

How much money do you need to invest in a CD?

There are minimums to purchase a CD, which vary, but a ballpark figure is around $500, depending on where you buy them.

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Although we do our best to recognize all Eligible Direct Deposits, a small number of employers, payroll providers, benefits providers, or government agencies do not designate payments as direct deposit. To ensure you're earning 3.80% APY, we encourage you to check your APY Details page the day after your Eligible Direct Deposit arrives. If your APY is not showing as 3.80%, contact us at 855-456-7634 with the details of your Eligible Direct Deposit. As long as SoFi Bank can validate those details, you will start earning 3.80% APY from the date you contact SoFi for the rest of the current 30-day Evaluation Period. You will also be eligible for 3.80% APY on future Eligible Direct Deposits, as long as SoFi Bank can validate them.

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SoFi Bank shall, in its sole discretion, assess each account holder’s Eligible Direct Deposit activity and Qualifying Deposits throughout each 30-Day Evaluation Period to determine the applicability of rates and may request additional documentation for verification of eligibility. The 30-Day Evaluation Period refers to the “Start Date” and “End Date” set forth on the APY Details page of your account, which comprises a period of 30 calendar days (the “30-Day Evaluation Period”). You can access the APY Details page at any time by logging into your SoFi account on the SoFi mobile app or SoFi website and selecting either (i) Banking > Savings > Current APY or (ii) Banking > Checking > Current APY. Upon receiving an Eligible Direct Deposit or receipt of $5,000 in Qualifying Deposits to your account, you will begin earning 3.80% APY on savings balances (including Vaults) and 0.50% on checking balances on or before the following calendar day. You will continue to earn these APYs for (i) the remainder of the current 30-Day Evaluation Period and through the end of the subsequent 30-Day Evaluation Period and (ii) any following 30-day Evaluation Periods during which SoFi Bank determines you to have Eligible Direct Deposit activity or $5,000 in Qualifying Deposits without interruption.

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Separately, SoFi members who enroll in SoFi Plus by paying the SoFi Plus Subscription Fee every 30 days can also earn 3.80% APY on savings balances (including Vaults) and 0.50% APY on checking balances. For additional details, see the SoFi Plus Terms and Conditions at https://www.sofi.com/terms-of-use/#plus.

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May
20
2024

Pros and Cons of Raising the Minimum Wage

By | Family Finances, Life & Career, money | Comments Off on Pros and Cons of Raising the Minimum Wage

Raising the minimum wage, which is a hot-button political issue, could have immediate effects on the lives of low-wage hourly workers. It could help them to move out of poverty and keep up with inflation. Some economists argue that other pros of raising the minimum wage could include increased consumer spending, reduced government assistance (and increased tax revenue), and stronger employee retention and morale.

Alternatively, other financial experts point to the cons of raising the minimum wage, including potentially increasing the cost of living, reducing opportunities for inexperienced workers, and triggering more unemployment.

Learn more here, including the purpose of the federal minimum wage, where the minimum wage currently stands, and the pros and cons of raising it.

Key Points

•   Raising the minimum wage could help low-wage workers escape poverty and keep up with inflation.

•   Increased wages may lead to higher consumer spending and reduced reliance on government assistance.

•   Higher labor costs from wage increases could lead to unemployment and higher product prices.

•   A raised minimum wage might improve employee retention and performance in businesses.

•   The federal minimum wage has remained at $7.25 per hour since 2009, despite inflation.

What Is the Federal Minimum Wage in 2024?

The federal minimum wage in 2024 is $7.25 per hour. The last time that minimum wage increased was on July 24, 2009, when it grew $0.70 from $6.55 an hour. This was part of a three-phased increase enacted by Congress in 2007.

It’s worth noting that tipped employees (say, waiters) have a different rate. The current federal tipped minimum wage is $2.13, as long as the worker’s tips make up the difference between that and the standard minimum wage.

Some states have their own minimum wage laws with a higher (or lower) starting wage than the federal minimum. In such states, employers must pay out the higher of the two minimum wages.

Here are some minimum wage fast facts:

•   The highest current minimum wage is in Washington, D.C., where it is $17.00.

•   There are 58 cities and counties with minimum wages higher than their state’s figures. Of these, the city of Tukwila, Washington, currently has the highest wage at $20.29 per hour.

•   As of 2023, about 20.6 million US workers make less than $15 per hour, and many are making the federal minimum wage of $7.25 per hour or less.

•   While the minimum wage has been stagnant since 2009, inflation has not. The spending power of $7.25 in 2009 is equivalent to $10.55 today. This means that $7.25 can buy today about 68% (or just over two-thirds) of what it could buy in 2009.


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What Is the Purpose of the Minimum Wage?

So why was the minimum wage originally created? The minimum wage was an idea that gained traction during the Great Depression era. During that time, President Franklin D. Roosevelt worked with Congress to pass the Fair Labor Standards Act of 1938, which officially established the minimum wage. Even then, politicians bickered over the hourly rate and potential impacts on the economy, and the final legislation (25 cents an hour) was not what FDR originally had in mind.

Regardless of the final number that Congress landed on, FDR’s vision for this minimum wage law was to “end starvation wages and intolerable hours,” according to the Department of Labor. The Legal Information Institute of Cornell Law School paints an even clearer picture: The minimum wage was designed to create a minimum standard of living to protect the health and well-being of employees.

In short, early proponents of the minimum wage legislation intended for it to be a living wage. And as the Kenan Institute of Private Enterprise points out, in today’s economy, “there is a stark difference between the federal minimum wage and a living wage.”

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Benefits of Raising the Minimum Wage

Many economists point to several pros of raising the minimum wage, including the following:

Helping Families Get Out of Poverty

Even without minimum wage increases in today’s market, inflation is skyrocketing. In July 2022, it was up 9.1% year-over-year, a four-decade high. In 2023, it was 4.98%. The average American family is likely trying to cut grocery costs, gas prices, and utility bills.

The Raise the Wage Act of 2023 focuses on raising the minimum wage to $17 an hour by 2028, giving almost 30 million American workers a long overdue raise and more buying power to make ends meet.

While raising the minimum wage will not stop inflation’s effects, it could help families more easily afford basic necessities. It can also fulfill the legislation’s original intention of eliminating starvation wages and establishing a minimum standard of living.

Increasing Consumer Spending

Multiple studies over the last decade have demonstrated that low wage earners are more likely to put their income directly back into the economy. That’s because low wage workers spend a larger portion of their budget on immediate needs, like food, clothing, transportation, and shelter.

Increased consumer spending is a boon to the economy, as it is a positive economic indicator reflecting consumer confidence in the market — and brings more revenue to small businesses and corporations alike.

Increasing Federal Revenues

Reports have found that federal spending would both increase and decrease if the minimum wage were raised. While those with newly raised wages might rely on government assistance less (for example, there could be reduced spending on nutrition programs like SNAP), workers who lose their jobs as a result of minimum wage increases will put an excess burden on unemployment.

However, increased tax revenue from higher wages should boost federal revenues overall.

Increasing Employee Retention and Performance

The theory of efficiency wages suggests that higher-paid employees are more motivated to work harder and thus produce more goods and services faster. If that theory is true, increasing the minimum wage could help businesses become more profitable.

Further, employees are more likely to stay with a company longer if they earn good wages. The longer an employee is with a company, the more skilled that employee can become — and thus more valuable to the business.

On top of that, employee turnover is expensive. Replacing an employee with a new candidate can cost up to 150% of the worker’s salary or possibly more. In many cases, it might be cheaper for a business to pay an employee a better salary to keep them from leaving. It could be cheaper than recruiting and training a new worker to replace them after they’ve left.

Cons of Raising the Minimum Wage

There are multiple downsides to raising the minimum wage to consider when debating this policy as well:

Increasing Labor Costs and Unemployment

The largest concern with raising the minimum wage is increased labor costs. If the minimum wage increased to $15 an hour, businesses would suddenly need to give raises to everyone making less than that.

But if some employees were making $10 to $15 an hour, they might not be thrilled to hear that other workers with less tenure and experience are suddenly being paid the same. And employees who were making $15 an hour or slightly above it may also expect a raise once entry-level workers are bumped to $15.

The problem? Not all businesses can afford that. Restaurants, for example, operate at a 3% to 5% profit margin. Increasing labor costs could shrink (or eliminate) their margins, meaning they might have to let go of some staff or go out of business.

Another aspect of this is that if employers have to raise their wages, they might well raise their prices, passing along the increase to their customers.

Increasing Cost of Living

As businesses adjust prices to accommodate higher labor costs, consumers should expect that their dollars won’t go as far as they used to. That is, many economists argue that minimum wage is correlated with inflation. Some say that if business owners have to raise the minimum wage they pay workers, they will pay along those costs to their customers, ratcheting up their prices and contributing to inflation.

That said, other economists paint inflation as the boogeyman of the minimum wage debate. For example, Daniel Kuehn, a research associate at The Urban Institute, has said that, though increasing wages will increase the cost of goods and services, it’s not really a 1:1 ratio. In other words, it won’t be “enough for consumers to really feel a burn in their wallet.”

Recommended: Compare Texas Cost of Living to California Cost of Living

Decreasing Opportunity for Inexperienced Workers

Typically, employees without specialized skills — first-time workers in high school and college, people with disabilities, and the elderly — fill some minimum wage jobs to earn what might be considered entry-level salaries. But as employers are forced to pay workers more, some argue that companies will look for employees with more experience (or will invest in automated technology). This could make it more challenging for unskilled laborers to find work.

Handling the Effects of Raising the Minimum Wage

Businesses may need to adjust practices to pay employees a higher hourly rate if the federal or state minimum wage increases. Here are a few ways company leaders might be able to handle the effects of increased wages:

•   Raising prices: If a company’s labor costs go up, the company may need to offset those expenses with higher prices for its goods and services. Paying attention to what competitors are doing and how consumers are reacting to price hikes can be helpful in determining how much you raise prices.

•   Working with independent contractors: Independent contractors might be more affordable than full-time employees for specific job duties. For instance, the employer would save on paying benefits (though that could mean staff workers get laid off and go on unemployment).

Before establishing an independent contractor model at your business, it’s a good idea to research the guardrails around independent contractors, as defined by the IRS.

•   Automating some positions: Technology continues to offer new ways to automate certain business functions, which may allow employers to reduce headcount, avoid future hires, or reassign existing employees to more revenue-generating work.

•   Reducing hours or cutting costs: Business owners who do not want to lose any employees might be able to reduce overall hours or find other ways to cut costs instead (perhaps a less expensive benefits package, for instance).

•   Getting creative: Offsetting increased labor costs can be as easy as generating more business. But then generating more business isn’t always so easy. Some creative ideas to get customers in the door could include loyalty programs or offering low-cost alternatives for budget-conscious customers.

The Takeaway

The original intention for establishing a minimum wage was to enable workers to have a standard of living that allowed for their health and well-being. While opponents may still argue over “living wage vs. starting wage,” many signs point to today’s federal minimum wage not being enough to have a basic standard of living. Raising the minimum wage has several pros, but it’s important to remember that there are many negative effects to minimum wage increases as well. The economic solution may not be simple, but it will likely be a debate that’s in the spotlight today and in the near future.

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FAQ

How does increasing the minimum wage affect the economy?

Some economists argue that increasing the minimum wage encourages consumer spending, helps families out of poverty, and boosts tax revenue while reducing tax-funded government assistance. Other economists point out the cons of raising the minimum wage, like increased inflation and unemployment.

How does decreasing the minimum wage affect the economy?

In general, the discussion around minimum wage is about increasing it. Economists and politicians are not considering decreasing the minimum wage; doing so would send more families into poverty and decrease consumer spending.

Why are state minimum wages different?

States are able to enact their own laws that supplement or deviate from federal laws. Many states with a higher cost of living, like California and Washington, have increased their minimum wage to roughly double the federal minimum. If a state’s minimum wage differs from the federal minimum wage, employers must pay the higher of the two rates.

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SoFi members with Eligible Direct Deposit activity can earn 3.80% annual percentage yield (APY) on savings balances (including Vaults) and 0.50% APY on checking balances. Eligible Direct Deposit means a recurring deposit of regular income to an account holder’s SoFi Checking or Savings account, including payroll, pension, or government benefit payments (e.g., Social Security), made by the account holder’s employer, payroll or benefits provider or government agency (“Eligible Direct Deposit”) via the Automated Clearing House (“ACH”) Network during a 30-day Evaluation Period (as defined below).

Although we do our best to recognize all Eligible Direct Deposits, a small number of employers, payroll providers, benefits providers, or government agencies do not designate payments as direct deposit. To ensure you're earning 3.80% APY, we encourage you to check your APY Details page the day after your Eligible Direct Deposit arrives. If your APY is not showing as 3.80%, contact us at 855-456-7634 with the details of your Eligible Direct Deposit. As long as SoFi Bank can validate those details, you will start earning 3.80% APY from the date you contact SoFi for the rest of the current 30-day Evaluation Period. You will also be eligible for 3.80% APY on future Eligible Direct Deposits, as long as SoFi Bank can validate them.

Deposits that are not from an employer, payroll, or benefits provider or government agency, including but not limited to check deposits, peer-to-peer transfers (e.g., transfers from PayPal, Venmo, etc.), merchant transactions (e.g., transactions from PayPal, Stripe, Square, etc.), and bank ACH funds transfers and wire transfers from external accounts, or are non-recurring in nature (e.g., IRS tax refunds), do not constitute Eligible Direct Deposit activity. There is no minimum Eligible Direct Deposit amount required to qualify for the stated interest rate. SoFi members with Eligible Direct Deposit are eligible for other SoFi Plus benefits.

As an alternative to Direct Deposit, SoFi members with Qualifying Deposits can earn 3.80% APY on savings balances (including Vaults) and 0.50% APY on checking balances. Qualifying Deposits means one or more deposits that, in the aggregate, are equal to or greater than $5,000 to an account holder’s SoFi Checking and Savings account (“Qualifying Deposits”) during a 30-day Evaluation Period (as defined below). Qualifying Deposits only include those deposits from the following eligible sources: (i) ACH transfers, (ii) inbound wire transfers, (iii) peer-to-peer transfers (i.e., external transfers from PayPal, Venmo, etc. and internal peer-to-peer transfers from a SoFi account belonging to another account holder), (iv) check deposits, (v) instant funding to your SoFi Bank Debit Card, (vi) push payments to your SoFi Bank Debit Card, and (vii) cash deposits. Qualifying Deposits do not include: (i) transfers between an account holder’s Checking account, Savings account, and/or Vaults; (ii) interest payments; (iii) bonuses issued by SoFi Bank or its affiliates; or (iv) credits, reversals, and refunds from SoFi Bank, N.A. (“SoFi Bank”) or from a merchant. SoFi members with Qualifying Deposits are not eligible for other SoFi Plus benefits.

SoFi Bank shall, in its sole discretion, assess each account holder’s Eligible Direct Deposit activity and Qualifying Deposits throughout each 30-Day Evaluation Period to determine the applicability of rates and may request additional documentation for verification of eligibility. The 30-Day Evaluation Period refers to the “Start Date” and “End Date” set forth on the APY Details page of your account, which comprises a period of 30 calendar days (the “30-Day Evaluation Period”). You can access the APY Details page at any time by logging into your SoFi account on the SoFi mobile app or SoFi website and selecting either (i) Banking > Savings > Current APY or (ii) Banking > Checking > Current APY. Upon receiving an Eligible Direct Deposit or receipt of $5,000 in Qualifying Deposits to your account, you will begin earning 3.80% APY on savings balances (including Vaults) and 0.50% on checking balances on or before the following calendar day. You will continue to earn these APYs for (i) the remainder of the current 30-Day Evaluation Period and through the end of the subsequent 30-Day Evaluation Period and (ii) any following 30-day Evaluation Periods during which SoFi Bank determines you to have Eligible Direct Deposit activity or $5,000 in Qualifying Deposits without interruption.

SoFi Bank reserves the right to grant a grace period to account holders following a change in Eligible Direct Deposit activity or Qualifying Deposits activity before adjusting rates. If SoFi Bank grants you a grace period, the dates for such grace period will be reflected on the APY Details page of your account. If SoFi Bank determines that you did not have Eligible Direct Deposit activity or $5,000 in Qualifying Deposits during the current 30-day Evaluation Period and, if applicable, the grace period, then you will begin earning the rates earned by account holders without either Eligible Direct Deposit or Qualifying Deposits until SoFi Bank recognizes Eligible Direct Deposit activity or receives $5,000 in Qualifying Deposits in a subsequent 30-Day Evaluation Period. For the avoidance of doubt, an account holder with both Eligible Direct Deposit activity and Qualifying Deposits will earn the rates earned by account holders with Eligible Direct Deposit.

Separately, SoFi members who enroll in SoFi Plus by paying the SoFi Plus Subscription Fee every 30 days can also earn 3.80% APY on savings balances (including Vaults) and 0.50% APY on checking balances. For additional details, see the SoFi Plus Terms and Conditions at https://www.sofi.com/terms-of-use/#plus.

Members without either Eligible Direct Deposit activity or Qualifying Deposits, as determined by SoFi Bank, during a 30-Day Evaluation Period and, if applicable, the grace period, or who do not enroll in SoFi Plus by paying the SoFi Plus Subscription Fee every 30 days, will earn 1.00% APY on savings balances (including Vaults) and 0.50% APY on checking balances.

Interest rates are variable and subject to change at any time. These rates are current as of 1/24/25. There is no minimum balance requirement. Additional information can be found at http://www.sofi.com/legal/banking-rate-sheet.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.


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18
2024
What Is Market Value? How to Calculate and Use It

Market Value: Definition and Methods to Calculate It

By | Growing Wealth, invest, Investing, Terminology | Comments Off on Market Value: Definition and Methods to Calculate It

Market value is a common term used in value investing to describe how much a company or asset is worth on exchanges and financial markets. Essentially it is the value of a security in the eyes of market investors. Understanding the current standing of a business in its particular industry and the broader market is important when making investing decisions.

Key Points

•   Market value is the price at which an asset would trade in a competitive auction setting.

•   It is determined by multiplying the current share price by the number of outstanding shares.

•   Factors influencing market value include company performance, industry trends, and overall market conditions.

•   Market value can fluctuate greatly over time due to changes in investor sentiment and market dynamics.

•   Various methods to calculate market value include income approaches, asset-based approaches, and market comparison approaches.

What Is Market Value?

Market value, also referred to as OMV, market capitalization, or “open market valuation,” is the price of an asset in an investment marketplace or the value the asset has within a community of investors. It is calculated by multiplying current share price in a marketplace by the number of outstanding shares. Read on to learn what market value is and how to calculate market value.

The market value represents the price that investors will pay for an asset, and therefore changes significantly over time. The more investors will pay for the asset, the higher the market value.

What investors are willing to pay depends on various factors, including the fundamentals of the asset itself, as well as the business cycle and current levels of demand for that asset. Market value could be anything from under $1 million for small businesses to more than $1 trillion for large corporations.

It’s easy to determine the market value of frequently traded assets (by looking at their current prices), but harder to determine the market value of illiquid assets, such as real estate or a company, that don’t trade very often. Market value per share is a company’s market value divided by its number of shares.

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Factors that Impact Market Value

Many factors determine market value, including a company’s profitability and its debt levels. Market value fluctuates significantly over time. Market values often move in tandem with the overall market sentiment.

During bull markets or economic expansions, market values often increase, and during bear markets they go down. Other factors influencing market value include:

•   The company’s performance

•   Long-term growth potential

•   Supply and demand of the asset

•   Company profitability

•   Company debt

•   Overall market trends

•   Industry trends

•   Valuation ratios such as earnings per share, book value per share, and price-to-earnings ratio (P/E ratio)

Earnings per Share

The higher a company’s earnings per share, the more profitable it is. A more profitable business has a higher market value, and vice versa.

Book Value per Share

Investors calculate a company’s book value per share by dividing its equity by its total outstanding shares. A company with a higher book value than market value may have an undervalued stock.

Price-to-Earnings Ratio (P/E Ratio)

Investors calculate P/E ratio by dividing a company’s current stock price by its earnings per share amount. A higher P/E ratio means a stock’s price market value might be high relative to its earnings.

💡 Quick Tip: When you’re actively investing in stocks, it’s important to ask what types of fees you might have to pay. For example, brokers may charge a flat fee for trading stocks, or require some commission for every trade. Taking the time to manage investment costs can be beneficial over the long term.

How Is Market Value Calculated?

There are multiple ways to calculate market value. Here’s a look at a few of them:

Income method

There are two methods of calculating market value using income:

•   Discounted Cash Flow (DCF): To find discounted cash flow, investors project a company’s future cash flow and then discount it to find its present value. The amount it gets discounted reflects current market interest rates along with the amount of risk the business has.

•   Capitalized Earnings Method: With capitalized earnings, investors find the value of a stable, income-producing property by taking its net operating income over time and dividing it by the capitalization rate. The capitalization rate is an estimate of how much potential return on investment the asset has.

Assets Method

Using the assets approach, investors find an asset’s fair market value (FMV) by determining how many liabilities and adjusted assets a company has, including intangible assets, unrecorded liabilities, and off-balance sheet assets.

Market method

Using a market-based approach, there are a few more ways market value can be determined:

•   Public Company Comparable: This company compares similar businesses that are in the same industry or region and about the same size. Ratios like P/E, EV/Revenue, and EV/EBITDA can help compare all the similar companies.

•   Precedent Transactions: Using the precedent transactions method, market value reflects how much investors paid for other similar company’s stock in previous transactions. Investors can get a sense of how much a company’s value is by looking at similar companies.

Example of Market Value

Using the capitalized earnings valuation method, here’s an example of the market value calculation. The formula used when calculating via capitalized earnings is as such:

Market value = Earnings/capitalization rate

Earnings are rather self-explanatory, and the capitalization rate is the required rate of return for investors, a number reached by subtracting a company’s expected growth rate from the investor’s expected rate of return. For this example, we’ll make things simple and say that the capitalization rate is 10%, and the company’s earnings are $1 million

Using the formula: Market value = $1 million/10%

That calculates to $10,000,000.

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Limitations of Market Value

Market value is a very useful tool for understanding how much a company is worth and whether it is a good time to invest or sell its stock. However, it has a few limitations:

•   Fluctuation: Company stocks go up and down every day, and, therefore market value also always changes. Various factors affect market value, and it is very dynamic, which is important for investors to keep in mind when making trading decisions.

•   Precedent data: It’s easier to find market value for established businesses because it requires historical pricing data to find it. New businesses don’t have such data, making it harder for investors to determine their market value.

The Takeaway

Market value is very useful for analyzing a stock. It is easiest to calculate market value of assets such as stocks and futures that are traded on exchanges because it is easy to access their market prices. Market value for less frequently traded assets can be difficult and requires some assumptions and calculations.

Calculating market value can be useful for investors of all stripes, but it can be easy to get lost in the math. Be sure to double-check your math and consider the limitations of market value before making investing decisions.

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FAQ

Is market value the same as market capitalization?

Market value is the price at which a buyer purchases an asset, and can refer to a company or a security such as a stock, future, or asset. Market cap is the value of the total number of outstanding shares of a company, based on their current market value.

Is market value the same as book value?

Market value and book value per share, or explicit value, are different and can be very different amounts, but they are often used in conjunction by investors looking to gain an understanding of an asset’s value. Book value is the net value of a company’s balance sheet assets, while market value is the price at which a buyer purchases an asset.

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SoFi Invest®

INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
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For a full listing of the fees associated with Sofi Invest please view our fee schedule.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

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May
18
2024
What Happens When a Public Company Goes Private?

What Happens When A Company Goes Private?

By | Growing Wealth, invest, Investing | Comments Off on What Happens When A Company Goes Private?

While there are plenty of benefits to going public, there are also some downsides to being listed on a major stock exchange. Public companies must abide by strict government compliance and corporate government statutes and answer to shareholders and regulatory bodies. Plus they’re subject to the whims of the broader stock market on a regular basis.

So, public companies can opt to go private and delist from a public stock exchange. What happens when a public company goes private? Here’s what you need to know about that process.

Key Points

•   When a company transitions from public to private, it is delisted from stock exchanges and its shares are no longer publicly traded.

•   This change means the company is exempt from the Sarbanes-Oxley Act and other stringent public compliance requirements.

•   Going private can reduce financial and pricing stability due to decreased liquidity and fewer financing options.

•   The process involves a buyout through a tender offer, often funded by private equity and requiring shareholder approval.

•   Privatization allows for more autonomous control over business decisions and operations by reducing public and governmental scrutiny.

What Is Going Private?

When a company goes from public to private, the company is delisted from a stock exchange and its shareholders can no longer trade their shares in a public market. It also means that a private company no longer has to abide by the Sarbanes-Oxley Act of 2002. That legislation required publicly-traded companies to accommodate expansive and costly regulatory requirements, especially in the compliance risk management and financial reporting areas. (The legislation was created by lawmakers to help protect investors from fraudulent financial practices by corporations.)

Going private may also mean less pricing and financial stability, as private company shares typically have less liquidity than a public company traded on a stock exchange. That can leave a private company with fewer financing options to fund operations.

Going private also changes the way a company operates. Without public shareholders to satisfy, the company’s founders or owners can control both the firm’s business decisions and any shares of private stock. Private companies can consolidate power among one or a few owners. That can lead to quicker business decisions and a clear path to take advantage of new business opportunities.

By definition, a private company, or a company that has been “privatized”, may be owned by an individual or a group of individuals (i.e., a consortium) that also has a specific number of shareholders.

Unlike traditional stocks, investors in a private company do not purchase shares through a stock broker or through an online investment platform. Instead, investors purchase private equity shares from the company itself or from existing shareholders.

💡 Quick Tip: Before opening an investment account, know your investment objectives, time horizon, and risk tolerance. These fundamentals will help keep your strategy on track and with the aim of meeting your goals.

What Is Privatization?

Privatization is the opposite of an initial public offering. It’s the process by which a company goes from being a publicly traded company to being a private one. A private company may still offer shares of stock, but those shares aren’t available on public market exchanges. There’s no need to satisfy public shareholders and the company has less governmental oversight into its governance and documents.

(Note that privatization is also a term used to describe when a public or government organization switches to ownership by a private, non-governmental group.)

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What Happens if You Own Shares of a Company That Goes Private?

If shareholders approve a tender offer to take a public company private, they’ll each receive a payment for the number of shares that they’re giving up. Typically, private investors pay a premium that exceeds the current share price and shareholders receive that money in exchange for giving up ownership in the company.

This is the opposite of IPO investing, in which the public buys stock in a newly listed company, and private owners have a chance to cash out.

💡 Recommended: Partner Buyout Financing

Why a Company May Go Private

Likely the biggest reason why a company would choose to go private are the costs associated with being a public company (largely to accommodate regulatory demands from local, state, and federal governments).

Those costs may include the following potential corporate budget challenges:

•   The legal, accounting, and compliance costs needed to accommodate company financial filings and associated corporate governance oversight obligations.

•   The costs needed to pay compliance, investor relations, and other staffing needs – or the hiring of third-party specialty firms to handle these obligations.

•   The costs associated with paying strict attention to company share price – a public company always has to keep its eye on maximizing its stock performance and on keeping shareholders satisfied with the firm’s stock performance.

In addition, going private enables companies to free up management and staff to turn their attention to firm financial growth, instead of regulatory and compliance issues or shareholder concerns. Some public companies struggle to invest for the long-term because they’re worried about meeting short-term targets to keep their stock price up.

Going private also enables companies to keep critical financial and operational data away out of the public record — and the hands of competitors. Privatization could also help companies avoid lawsuits from shareholders and curb some litigation risk.

How to Take a Company Private

Typically, companies that go private work with either a private-equity group or a private-equity firm pooling funds to “buy out” a public company’s entire amount of publicly-traded stock. This typically requires a group of investors since, in most cases, it takes an enormous amount of financial capital to buy out a company with hundreds of millions (or even billions) of dollars linked to its publicly-traded stock.

Often a consortium of private equity investors gets help financing with a privatization campaign from an investment bank or other large financial institution. The fund usually comes in the form of a massive loan — with interest — that the consortium can use to buy out a public company’s shares.

With the funding needed to close the deal on hand, the private equity consortium makes a tender offer to purchase all outstanding shares in the public company, which existing shareholders vote on. If approved, existing shareholders sell their stock to the private investors who become the new owners of the company.

The goal is that the private investors will take the gains accrued through stronger company revenues and rejuvenated stock, to pay down the investment banking loan, pay off any investment banking fees accrued, and begin managing the income and capital gains garnered from their investment in the company. While this can take some time, the process of going private is much less intensive than the IPO process.

Company executives, meanwhile, can focus on growing the company. In many instances, newly-minted private companies may roll out a new business plan and prospectus that firm executives can share with potential shareholders, hopefully bringing more capital into the company. Sometimes private owners will plan to IPO the business again in the future.

💡 Quick Tip: Keen to invest in an initial public offering, or IPO? Be sure to check with your brokerage about what’s required. Typically IPO stock is available only to eligible investors.

Pros and Cons of Going Private

Taking a company private has both benefits and drawbacks for the company.

The Pros

In addition to lower costs, there are several other advantages to delisting a company.

•   Establishing privacy. When a company goes public, it relinquishes the right to keep the company private. By taking a company private, it makes it easier to operate outside of the public eye.

•   Fewer shareholders. Public companies don’t have to deal with external company sources that may make life difficult for company executives and may result in a loss of operational independence. Once a company goes private, the founders or new owners retain full control over the business and have the last word on all company decisions.

•   A private company doesn’t have to deal with financial regulators. A private company doesn’t need to file financial disclosures with the U.S. Securities and Exchange Commission and other government regulatory bodies. While a private company may have to file an annual report with the state where it operates, the information is limited and financial information remains private.

The Cons

There are some disadvantages to taking a company private.

•   Capital funding challenges. When a company goes private, it loses the ability to raise funds through the publicly-traded financial markets, which can be an easy and efficient way to boost company revenues. Yet by privatizing the company, publicly-funded capital is no longer an option. Such companies may have to borrow funds from a bank or private lender, or sell stock based on a state’s specific regulatory requirements.

•   The owner may have more legal liability. Private companies, especially sole proprietorships or general partnerships, aren’t protected from legal actions or creditors. If a private company is successfully sued in court, the court can garnish the business owner’s personal assets if necessary.

•   More powerful shareholders. While there are not as many shareholders at a private company, new owners, such as venture capitalists or private equity funds, may have strong feelings about the operational business decisions, and as owners, they may have more power over seeing their wishes carried out.

The Takeaway

Going private can be an advantage for companies that want more control at the executive level, and no longer want their shares listed on a public exchange. However, taking a company private may impact the company’s bottom line as corporate financing options thin out when public shareholders can no longer buy the company’s stock.

If a company you own stock in goes private, you will no longer own shares in that company or be able to buy them through a traditional broker. For investors, having different types of assets in an investment portfolio may be helpful in case something happens to or changes with one of them.

Ready to invest in your goals? It’s easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, and more. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).


Invest with as little as $5 with a SoFi Active Investing account.

FAQ

Is it good for a public company to go private?

Going private can have benefits for a public company, including lower costs related to legal, accounting, and compliance obligations, as well as costs associated with maximizing stock performance and keeping shareholders happy. In addition, going private may allow a company’s staff to focus more fully on financial growth, and keep critical company data out of the public record (and the hands of competitors).

However, there are potential drawbacks as well. For instance, a company may face capital funding challenges once it goes private since it can no longer raise funds through publicly-traded financial markets.

What happens to my private shares when a company goes public?

Once a company goes public (typically done through a process called an IPO, or initial public offering), your private shares become public shares, and they become worth the public trading price of the shares.

How long does it take for a public company to be private?

How long it takes for a public company to become private depends on the time it takes to complete the steps involved. For instance, the company has to buy out all of its publicly-traded stock; it usually works with a group of private investors to do this since the process is costly. Once they have the founding secured, a tender offer is made to purchase all outstanding shares in the public company, which the existing shareholders vote on. If that is approved, the shareholders sell their stock to the owners of the company. How long all this takes generally depends on the company and the specific situation.

Photo credit: iStock/Olezzo


Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

SoFi Invest®

INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.
For a full listing of the fees associated with Sofi Invest please view our fee schedule.


Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.

Investing in an Initial Public Offering (IPO) involves substantial risk, including the risk of loss. Further, there are a variety of risk factors to consider when investing in an IPO, including but not limited to, unproven management, significant debt, and lack of operating history. For a comprehensive discussion of these risks please refer to SoFi Securities’ IPO Risk Disclosure Statement. IPOs offered through SoFi Securities are not a recommendation and investors should carefully read the offering prospectus to determine whether an offering is consistent with their investment objectives, risk tolerance, and financial situation.

New offerings generally have high demand and there are a limited number of shares available for distribution to participants. Many customers may not be allocated shares and share allocations may be significantly smaller than the shares requested in the customer’s initial offer (Indication of Interest). For SoFi’s allocation procedures please refer to IPO Allocation Procedures.

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May
18
2024
A Guide to Callable Bonds

Callable Bonds (or Redeemable Bonds), Explained

By | Growing Wealth, invest, Investing | Comments Off on Callable Bonds (or Redeemable Bonds), Explained

Callable bonds give issuers the option to redeem the bond before it matures. They’re also referred to as redeemable bonds. Bond investors lend their money to entities or issuers for a certain period of time and in return investors receive interest on the principal. These entities typically return the borrowed principle to the bond investors by the bond’s maturity date.

An exception to this process of bond investing is using callable bonds, which allows the issuer to pay off its loans early by buying back its bonds before they reach their date of maturity. You can define a callable bond as one with a built-in call option.

Key Points

•   Callable bonds allow issuers the option to redeem the bond before its maturity date.

•   These bonds can be advantageous for issuers during periods of falling interest rates, allowing them to refinance at lower rates.

•   Investors receive higher interest rates on callable bonds to compensate for the risk of early redemption.

•   The value of callable bonds is influenced by changes in interest rates, with their desirability decreasing as interest rates fall.

•   There are various types of callable bonds, including optional redemption, sinking fund redemption, and extraordinary redemption bonds.

What Is a Callable Bond?

Callable bonds, also referred to as redeemable bonds, allow the issuer the right, but not the obligation, to redeem the bond before it reaches its maturity date. The entity that issues callable bonds has the right to prepay, or in other words, the bond is callable before its maturity date.

Issuers may use callable bonds when they expect interest rates to fall. That way, they can redeem their bonds and issue new ones at a lower coupon rate, reducing their overall interest expenses.


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How Do Callable Bonds Work?

When the issuer calls the bond, it pays investors the call price or the face value of the bond, along with the accrued interest to date. After that, the issuer no longer has to make payments on the bond.

Businesses may prefer callable bonds, since they have built-in flexibility that could lower costs in the future. For example, if market rates are 5% when a company first issues its bonds but they drop to 2.5%, a bond issuer paying 5% would call their bonds and get new ones at 2.5%.

Some bonds have call protection which forbids the issuer to buy it back for a certain period of time. During this period, the company can not call their bonds. However, at the end of this period, the issuer can redeem the bond at its specified call date.

Callable bond prices correlate to interest rates, since falling interest rates make callable bonds less valuable.

Finding the Value of Callable Bonds

The main difference between a non-callable bond and a callable bond is that a callable bond has the call option feature. This feature impacts the calculation of the value of the bond. To find the value of callable bonds, take the bond’s coupon rate and add 1 to it.

For example, a callable bond with a 7% coupon would be 1.07. Next, raise 1.07 to the number of years until the bond is callable. If the bond is callable in two years, you would raise 1.07 to the power of two, which would be 1.1449. Then, multiply that number by the bond’s par value or face value.

If the bond’s par value is $10,000, you would multiply $10,000 by 1.1449 to get 11,449, which is the value of the callable bond.

Recommended: How to Buy Bonds: A Guide for Beginners

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Types of Callable Bonds

Bonds have different types of issuers. Municipalities and corporations both may issue callable bonds. Here’s a look at three common types of callable bonds.

1. Optional Redemption Callable Bonds

Some municipal bonds have a redeemable option 10 years after the issue of the bond was issued. However, bonds with higher yields might have a protection or waiting period according to the bond’s maturity date. For example, a five-year bond might not be able to be recalled until two years after it is issued.

2. Sinking Fund Redemption Callable Bonds

This requires the issuer to recall a certain amount or all of the bonds according to a fixed schedule. A sinking fund is money that a company reserves on the side to pay off a bond.

3. Extraordinary Redemption Callable Bonds

Extraordinary redemption is when the issuer recalls the bond before maturity if certain specified events in the bond contract occur such as a business scenario that impacts bond revenue.

Callable Bond Example

A callable bond with a par value of $1,000 and a 5% coupon rate issued on January 1, 2022 has a maturity date of January 1, 2030. The annual interest payments investors would receive is $50. This bond has a protection feature which doesn’t allow the issuer to recall the bond until January 1, 2026, but after that date, the bond can be redeemed.

The issuer believes interest rates will decrease within the next four years and decides to recall the bond on January 1, 2026. If the investor bought the callable bond through their broker at its $1,000 par value, and the issuer chooses to redeem it when the protection period expires in 2026, they would calculate the value of the callable bond as follows:

•   Take the coupon rate and add 1 to it, to make 1.05.

•   Next, multiply 1.05 to the fourth power since the issuer will hold on to it for four years.

•   This calculation will yield 1.2155.

•   Next, multiply 1.255 by the bond’s par value of $1,000 to get $1,215, the value of the callable bond.

Interest and Callable Bonds

From the perspective of the callable bond issuer, falling interest rates are an opportunity to recall your bonds and lower your interest rate. While the investor is compensated at the outset with a higher yield or coupon rate for investing in callable bonds, they must be aware of the added risks associated with this investment.

If interest rates stay the same or increase, there’s a lower chance the issuer will recall its bonds. But if investors believe interest rates will drop prior to the bond’s maturity date, they should be compensated for this additional risk. The investor must determine if the higher yield from callable bonds is worth the risk of investment because the call feature is an advantage to the issuer, not the investor.


💡 Quick Tip: How to manage potential risk factors in a self-directed investment account? Doing your research and employing strategies like dollar-cost averaging and diversification may help mitigate financial risk when trading stocks.

Pros and Cons of Callable Bonds

Like any other investment, callable bonds have benefits and risks. It’s important to keep in mind the pros and cons of investing in callable bonds when considering a long-term investing strategy.

Callable bonds are financial instruments that may carry more risk for investors than noncallable bonds (bonds only paid out at maturity) because there is the chance of the bond being called prior to it reaching maturity.

Pros

 Cons
Companies issue callable bonds at higher interest rates to compensate for the risk of early redemption. This means the possibility of greater investment returns. If an issuer calls its bonds early as a result of lower interest rates, bond investors risk not being able to find bonds with lower coupon rates. This could pose a challenge for income-seeking investors who want a reliable stream of passive income from bond investing.
One of the benefits of callable bonds is the option to call the bond early. Instead of waiting until the bond reaches maturity, the issuer can recall the bond earlier to suit their financial business needs. Callable bond investors who pay a premium, or more than a bond’s face value risk only getting back the face value of the bond. This means the investor would lose their money on the premium they already paid.
Callable bonds have benefits that mostly favor the issuer. When interest rates fall, the company can redeem the bonds early and issue new bonds at a lower rate to save on interest payments. Another risk is the bond’s maturity. The longer it takes for the bond to mature, the greater the likelihood for the bond to be called early, especially if there is a change in interest rates. Investing in bonds with a shorter maturity date carries lower interest rate risk.

The Takeaway

Again, callable bonds give issuers the option to redeem the bond before it matures. They’re also referred to as redeemable bonds. Callable bond investors lend their money to entities or issuers for a certain period of time and in return investors receive interest on the principal.

Some investors might consider buying callable bonds as one way to diversify an investment portfolio or to achieve higher yield, however, it’s important for investors to keep the risks associated with this investment top of mind. In an environment where interest rates are falling, callable bonds may not work for long-term investors looking for income.

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FAQ

Are callable bonds a good investment?

Callable bonds may be a good investment depending on an investor’s strategy, risk tolerance, and time horizon, but the overriding interest rate environment may also determine how good of an investment they are as well.

What does it mean if a bond is callable?

If a bond is callable, it means that bonds can be redeemed or paid off by their issuer before they reach their maturity date.

What is the call rule on a callable bond?

The call rule on callable bonds refers to the ability of a bond to be redeemed or repaid by its issuer prior to its maturity date.

What happens to callable bonds when interest rates rise?

When interest rates rise, callable bonds are less likely to be called, though there are no guarantees.

Are callable bonds cheaper?

Generally, callable bonds tend to be less expensive than normal bonds because of the call option, which are of value to their issuer, and may lead to a relative discount for the buyer.

Do callable bonds have higher yields?

Callable bonds do tend to have higher yields, but often not greatly so, and there’s no guarantee that the yields would be higher than those of other types of bonds.

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