Is income investing a good idea?

Income investing may be a good idea for investors looking for a way to generate regular income from their investments. Additionally, income investing can be a good way to diversify one’s portfolio and reduce overall portfolio risk.

MoneyHH Archives | Page 5 of 25

Q: What Is Income Investing?

An income investing strategy is an approach to investing that focuses on generating income rather than capital gains. Income investors typically seek out investments that provide a regular income stream, such as dividends from stocks, interest from bonds, or rental payments from a property.

Q: What’s the difference between income investing and growth investing?

Income investing is focused on generating regular cash flow through dividends, rent, or interest payments, while growth investing is focused on capital appreciation.

Q: What is the best investment for income?

There is no single best investment for income. Income-producing investments include stocks, bonds, and real estate. Each has different characteristics, so it is important to consider risk tolerance, liquidity needs, and investment objectives when choosing an investment.

Jun

2024

What Is an Income Investing Strategy?

By Michael Flannelly | Growing Wealth, invest, Investing | Comments Off

An income investing strategy focuses on generating income from your principal rather than growth, i.e. capital gains. Income investors typically seek out investments that provide a regular income stream, such as dividends from stocks, interest from bonds, or rental payments from a property.

Investors might be interested in income investing in order to create an additional income stream during their working years. Other investors may focus on generating monthly income during retirement. Income investors need to take into account several factors, including the tax implications of different types of income.

How Income Investing Works

Income investing can be a way to generate a passive income stream that supplements ordinary income as well as retirement income. Rather than creating a portfolio that’s solely focused on capital gains, i.e. growth, an income investing strategy is geared toward setting up one or more sources of steady income.

Again, dividend-paying stocks, interest-bearing bonds, and real estate proceeds are common types of income investments that may provide steady cash flow. While many people associate investment income with retirement, many investors seek to establish other income streams long before that.

That said, these two aims — growth and income — are not mutually exclusive. In fact, an income-generating portfolio must also have a growth component, in order to keep up with inflation.

Types of Income Investing Strategies

There are a range of income investing assets and strategies that investors can adopt, depending on their goals and preferences. For example, when creating an income-focused portfolio, it’s important to consider your risk tolerance, as different income investments may have different risk profiles.

1. Dividend Stocks

Dividend stocks are stocks that pay out regular dividends to shareholders. Not all companies pay dividends. Companies that do usually pay dividends quarterly, and they can provide a reliable source of income for investors.

Income investors are generally attracted to companies that pay out reliable dividends, like the companies in the S&P 500 Dividend Aristocrats index. Companies in this index have increased dividends every year for the last 25 consecutive years.

• Dividend Yield

One metric that income investors should consider is the dividend yield. While dividends are a portion of a company’s earnings paid to investors, expressed as a dollar amount, dividend yield refers to a stock’s annual dividend payments divided by the stock’s current price, and expressed as a percentage.

Dividend yield is one way of assessing a company’s earning potential.

While a high dividend yield might be attractive to some investors, risks are also associated with high-yield investments. Investors who want regular and consistent income tend to avoid stocks that pay high yields in favor of dividend aristocrats that may pay lower yields.

2. Bonds

Bonds are a debt instrument that normally make periodic interest payments to investors. Also known as fixed-income investments, bonds are typically less risky than stocks and can provide a steady stream of income. The bond’s yield, or interest rate, determines the interest income payment.

There are various bonds that fixed-income investors can consider. For example, government bonds are debt securities issued by a government to support government spending and public sector projects. Government bonds — like U.S. Treasuries and municipal bonds — are generally less risky than other types of bonds and can provide tax-advantaged income and returns.

Investors can also lend money to businesses through corporate bonds, which are debt obligations of the corporation. In return for money to fund operations, companies make periodic interest payments to investors. Corporate bonds carry a relatively higher level of risk than government bonds but also provide higher yields.

However, not all bonds offer yield to investors interested in generating regular income. Some bonds, called zero-coupon bonds, don’t pay interest at all during the life of the bond.

The upside of choosing zero-coupon bonds is that by forgoing annual interest payments, it’s possible to purchase the bonds at a deep discount to par value. This means that when the bond matures, the issuer pays the investor more than the purchase price.

Recommended: How to Buy Bonds: A Guide for Beginners

3. Real Estate

Real estate may be a great source of income for investors. Rents paid by tenants act as a regular income payout. Real estate may also offer long-term price growth, in addition to some tax benefits.

There are several ways to invest in real estate, including buying rental properties and investing in real estate investment trusts (REITs).

Recommended: Pros & Cons of Investing in REITs

4. Savings Accounts

Savings accounts are a safe and easy way to earn interest on cash. Savings accounts and other cash-equivalent saving vehicles like high-yield savings accounts or certificates of deposits (CDs) are often considered very low risk. But they also typically offer lower interest rates than you might see with other investments. Because these interest rates are typically lower than the inflation rate, inflation can erode the value of the money in these savings accounts longer term.

In addition, when you purchase a CD it may have more stringent minimum deposit requirements, as well as keeping your money locked up for a specific period of time. Still, they can be a low-risk way to earn income.

5. Money Market Accounts

A money market account (MMA) is an FDIC-insured deposit account that typically pays higher interest rates than a traditional savings account. However, MMAs may be more restrictive than a savings account, often only allowing a certain number of withdrawals each month using checks or a debit card.

Also, money in a money market account can be invested by the bank in government securities, CDs, and commercial paper — which are all considered relatively low-risk investments. With a traditional savings account, money is not invested.

But unlike most investments, money market accounts at most banks are FDIC-insured up to $250,000 for an individual, or $250,000 per co-owner in the case of joint accounts. In some cases investing in a money market account may earn a higher interest rate while still maintaining FDIC-insurance protection.

6. Mutual Funds and ETFs

Investors who don’t want to pick individual stocks and bonds to invest in can always look to mutual funds and exchange-traded funds (ETFs) that have an income investing strategy.

There are many passively and actively managed funds that invest in a basket of securities that provide interest and dividend income to investors. These funds allow investors to diversify their holdings by investing in a single security with high liquidity.

Understanding the Tax Implications of Income Investing

Another important aspect of investing for income is to consider the tax implications of different income-producing assets. Here are a few key considerations to be aware of:

• Dividends. Most dividends are considered ordinary dividends and are taxed as income. Qualified dividends are taxed at the lower capital gains rate. Be sure to know the difference.

• Real estate. Income from a rental property is generally taxed as income (although business deductions may apply). Dividend payouts from owning shares of a Real Estate Investment Trust (REIT) are typically higher than traditional equity dividends; these are also taxed as income. However, if there are profits from a REIT, these are taxed at the capital gains rate.

• Bonds. Bond income may be taxable, or not, depending on the issuer. Some municipal bonds are tax free at the federal and state level (if you live in the state where the bond was issued). Corporate bond income is taxed at the state and federal levels. U.S. Treasuries are generally taxed at the federal level, but not the state.

You may also owe ordinary income or capital gains tax if you make a profit when selling a bond.

As you can see, tax issues can be complex and it’s often necessary to consult a tax professional.

Example of an Income Investing Portfolio

When building a portfolio for any investing strategy, investors must consider their financial goals, risk tolerance, and time horizon. As with any investment portfolio, it’s possible to have lower or higher exposure to risk.

Here are some examples of hypothetical income investment allocations.

Lower Risk Tolerance

Asset type	Percent of holdings
Bonds (government and corporate)	60%
Dividend stocks	20%
Rental property or REITs	10%
Cash (savings account, money market account, and CDs)	10%

This is an illustrative portfolio and not intended to be investment advice. Nor is it a representation of an actual ETF or mutual fund. Please consider your risk tolerance and investment objective when creating your investment portfolio.

Moderate Risk Tolerance

Asset type	Percent of holdings
Bonds (government and corporate)	35%
Dividend stocks	30%
Rental property or REITs	30%
Cash (savings account, money market account, and CDs)	5%

Higher Risk Tolerance

Asset type	Percent of holdings
Bonds (government and corporate)	25%
Dividend stocks	30%
Rental property or REITs	45%
Cash (savings account, money market account, and CDs)	0%

Benefits and Risk of Income Investing

Like any investing strategy, there are both advantages and drawbacks to focusing on earning income through investments.

Benefits

The potential benefits of income investing include receiving a steady stream of payments, which can help to smooth out fluctuations in the market. In other words, even with a certain amount of market volatility, an income-generating strategy may produce income that provides a certain amount of ballast.

If an investor reinvests some or all of the income generated from a certain assets, whether bonds or dividend-paying stocks, this can add to the overall growth of the portfolio, thanks to compounding.

An income investing strategy may also provide diversification. For example, investing in REITs is considered a type of alternative investment strategy. That means, REITs don’t move in tandem with conventional assets like stocks, which may provide some protection against risk (although REITs can have their own risk factors to consider).

Risks

Investors who are pursuing an income investing strategy should be aware that investments that offer high yields may also be more volatile. The income from these investments may be less predictable than from more established investments, like blue chip stocks that pay out reliable dividends.

For example, a company with a high dividend yield may not be able to sustain that kind of payout and could suspend payment in the future.

When investing in bonds, investors need to know about the potential risks associated with fixed-income assets:

• Credit risk is when there is a possibility that a government or corporation defaults on a bond.

• Inflation risk is the potential that interest payments do not keep pace with inflation.

• Interest rate risk is the potential of fixed-income assets fluctuating in value because of a change in interest rates. For example, if interest rates rise, the value of a bond will decline, which could impact an investor who intends to sell some of their bond holdings.

Additionally, if investors take the income from their investment for day-to-day needs rather than reinvesting it, they may miss out on the benefits of compound returns. Investors could reinvest the income they earn on certain investments to take advantage of compounding returns and accelerate wealth building.

Factors to Consider When Building Your Income Investing Strategy

Building an income investing strategy takes work and time. Before creating a portfolio, you need to define your financial goals and consider your timeline for when you need the income streams. Below are some additional steps you could follow to create an income investing strategy:

• Assess your risk tolerance: It’s important to determine whether you want to invest more heavily in riskier assets, like dividend-paying stocks that may fluctuate in share price, or relatively safer securities, like interest-paying bonds.

• Choose your investments: As mentioned above, potential options for income investors include bonds, dividend stocks, and real estate investment trusts (REITs).

• Be mindful of taxes: Different types of income-producing assets may be taxed in different ways. It’s generally desirable to keep your portfolio tax efficient.

• Monitor your portfolio: It’s critical to regularly check in on your investments to ensure they are still performing according to your expectations.

• Rebalance as needed: If your portfolio gets out of alignment with your goals, consider making adjustments to get it back on track.

The Takeaway

An income investment strategy is, as it sounds, focused on using specific assets to provide income, not only growth (although income and growth strategies can work in harmony). Investing in dividend-paying stocks, interest-paying bonds, and other income-generating assets allows you to get the benefits of regular income streams and potential capital appreciation.

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

What’s the difference between income investing and growth investing?

The goal of income investing is to create a certain amount of steady income from different types of assets. Investing for growth is focused on the potential gains of the securities in a portfolio. In a sense, income investing can be more present focused, while growth investing may be oriented toward the longer term.

What is the best investment for income?

There are various income-generating investments, each with its own risk profile and tax considerations. When choosing the best income investments for you, be sure to consider how different factors might impact your plan.

What investments give you monthly income?

While it’s possible to obtain monthly income from various types of investments, even dividend-paying stocks (dividends are often paid quarterly), a common source of monthly income is property. If monthly income is important to you, be sure to select assets that can meet your goal.

Photo credit: iStock/LeszekCzerwonka

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Jun

2024

Guide to Zero-Coupon Certificates of Deposit (CDs)

By Rebecca Lake | Growing Wealth, Investing, money | Comments Off

A zero-coupon certificate of deposit or zero-coupon CD is a type of CD that’s purchased at a discount and pays out interest at maturity. Zero-coupon CDs can offer higher yields than standard CDs for investors who have the patience to wait until maturity to collect their original deposit and the interest earned.

Zero-coupon certificates of deposit are similar to bonds in that both are considered lower-risk, fixed-income instruments, but they serve different purposes in a portfolio. Understanding how a zero-coupon CD works can make it easier to decide if it’s a good investment for you.

What Is a Zero-Coupon CD?

To understand zero-coupon CDs, it’s important to know how a regular certificate of deposit works. A CD account, also referred to as a time-deposit or term-deposit account, is designed to hold money for a specified period of time. While the money is in the CD, it earns interest at a rate determined by the CD issuer — and the investor cannot add to the account or withdraw from it without penalty.

CDs are FDIC or NCUA insured when held at a member bank or credit union. That means deposits are insured up to $250,000.

CDs are some of the most common interest-bearing accounts banks offer, along with savings accounts and money market accounts (MMAs).

A zero-coupon certificate of deposit does not pay periodic interest. Instead, the interest is paid out at the end of the CD’s maturity term. This can allow the purchaser of the CD to potentially earn a higher rate of return because zero-coupon CDs are sold at a discount to face value, but the investor is paid the full face value at maturity.

By comparison, traditional certificates of deposit pay interest periodically. For example, you might open a CD at your bank with interest that compounds daily. Other CDs can compound monthly. Either way, you’d receive an interest payment in your CD account for each month that you hold it until it matures.

Once the CD matures, you’ll be able to withdraw the initial amount you deposited along with the compound interest. You could also roll the entire amount into a new CD if you’d prefer.

Remember: Withdrawing money from a CD early can trigger an early withdrawal penalty that’s typically equal to some of the interest earned.

How Do Zero-Coupon CDs Work?

Ordinarily when you buy a CD, you’d deposit an amount equal to or greater than the minimum deposit specified by the bank. You’d then earn interest on that amount for the entirety of the CD’s maturity term.

With zero-coupon CD accounts, though, you’re purchasing the CDs for less than their face value. But at the end of the CD’s term, you’d be paid out the full face value of the CD. The discount — and your interest earned — is the difference between what you pay for the CD and what you collect at maturity. So you can easily see at a glance how much you’ll earn from a zero-coupon CD investment.

In a sense, that’s similar to how the coupon rate of a bond works. A bond’s coupon is the annual interest rate that’s paid out, typically on a semiannual basis. The coupon rate is always tied to a bond’s face value. So a $1,000 bond with a 5.00% interest rate has a 5.00% coupon rate, meaning a $50 annual payout until it matures.

Real World Example of a Zero-Coupon CD

Here’s a simple example of how a zero-coupon CD works. Say your bank offers a zero-coupon certificate of deposit with a face value of $10,000. You have the opportunity to purchase the CD for $8,000, a discount of $2,000. The CD has a maturity term of five years.

You wouldn’t receive any interest payments from the CD until maturity. And since the CD has a set term, you wouldn’t be able to withdraw money from the account early. But assuming your CD is held at an FDIC- or NCUA-member institution, the risk of losing money is very low.

At the end of the five years, the bank pays you the full $10,000 face value of the CD. So you’ve essentially received $400 per year in interest income for the duration of the CD’s maturity term — or 5.00% per year. You can then use that money to purchase another zero-coupon CD or invest it any other way you’d like.

💡 Quick Tip: Typically, checking accounts don’t earn interest. However, some accounts do, and online banks are more likely than brick-and-mortar banks to offer you the best rates.

Tips When Investing in a Zero-Coupon CD

If you’re interested in zero-coupon CDs, there are a few things to consider to make sure they’re a good investment for you. Specifically, it’s important to look at:

• What the CD is selling for (in other words, how big of a discount you’re getting to its face value)

• How long you’ll have to hold the CD until it reaches maturity

• The face value amount of the CD (and what the bank will pay you in full, once it matures)

It’s easy to be tempted by a zero-coupon certificate of deposit that offers a steep discount between the face value and the amount paid out at maturity. But consider what kind of trade-off you might be making in terms of how long you have to hold the CD.

If you don’t have the patience to wait out a longer maturity term, or you need the money in the shorter term, then the prospect of higher returns may hold less sway for you. Also, keep in mind what kind of liquidity you’re looking for. If you think you might need to withdraw savings for any reason before maturity, then a standard CD could be a better fit.

Comparing zero-coupon CD offerings at different banks can help you find one that fits your needs and goals. You may also consider other types of cash equivalents, such as money market funds or short-term government bonds if you’re looking for alternatives to zero-coupon CDs.

Pros of Zero-Coupon CDs

Zero-coupon CDs have some features that could make them more attractive than other types of CDs. The main advantages of investing in zero coupon certificates of deposit include:

• Higher return potential than regular CDs

• Guaranteed returns, since you’re unable to withdraw money before maturity

• Suited for longer-term goals

• Can be federally insured

Zero-coupon CDs are lower-risk investments, which can make them more appealing than bonds. While bonds are considered lower-risk investments generally, if the bond issuer defaults, then you might walk away from your investment with nothing.

A zero-coupon certificate of deposit, on the other hand, does not carry this same default risk because your money is insured up to $250,000. There is, however, a risk that the CD issuer could “call” the CD before it matures (see more about this in the next section).

Cons of Zero-Coupon CDs

Every investment has features that may be sticking points for investors. If you’re wondering what the downsides of zero-coupon CDs are, here are a few things to consider:

• No periodic interest payments

• No liquidity, since you’re required to keep your money in the CD until maturity

• Some zero-coupon CDs may be callable, which means the issuer can redeem them before maturity, and the investor won’t get the full face value

• Taxes are due on the interest that accrues annually, even though the interest isn’t paid out until maturity

It may be helpful to talk to your financial advisor or a tax professional about the tax implications of zero-coupon CDs. It’s possible that the added “income” from these CDs that you have to report each year could increase your tax liability.

How to Collect Interest on Zero-Coupon CDs

Since zero-coupon CDs only pay out at interest at the end of the maturity term, all you have to do to collect the interest is wait until the CD matures. You can direct the bank that issued the CD to deposit the principal and interest into a savings account or another bank account. Or you can use the interest and principal to purchase new CDs.

It’s important to ask the bank what options you’ll have for collecting the interest when the CD matures to make sure renewal isn’t automatic. With regular CDs, banks may give you a window leading up to maturity in which you can specify what you’d like to do with the money in your account. If you don’t ask for the money to be out to you it may be rolled over to a new CD instead.

How to Value Zero-Coupon CDs

The face value of a zero-coupon CD is the amount that’s paid to you at maturity. Banks should specify what the face value of the CD is before you purchase it so you understand how much you’re going to get back later.

In terms of whether a specific zero-coupon CD is worth the money, it helps to look at how much of a discount you’re getting and what that equates to in terms of average interest earned during each year of maturity.

Purchasing a $10,000 zero-coupon CD for $8,000, for example, means you’re getting it at 20% below face value. Buying a $5,000 zero-coupon CD for $4,500, on the other hand, means you’re only getting a 10% discount.

Of course, you’ll also want to keep the maturity term in perspective when assessing what a zero-coupon CD is worth to you personally. Getting a 10% discount for a CD with a three-year maturity term, for example, may trump a 20% discount for a five-year CD, especially if you don’t want to tie up your money for that long.

The Takeaway

Investing in zero-coupon CDs could be a good fit if you’re looking for a lower-risk way to save money for a long-term financial goal, and you’d like a higher yield than most other cash equivalents.

Zero-coupon CDs are sold at a discount to face value, and while the investor doesn’t accrue interest payments annually, they get the full face value at maturity — which often adds up to a higher yield than many savings vehicles. And because the difference between the discount and the face value is clear, zero-coupon CDs are predictable investments (e.g. you buy a $5,000 CD for $4,000, but you collect $5,000 at maturity).

As with any investment, it’s important for investors to know the terms before they commit any funds. For example, zero-coupon CDs don’t pay periodic interest, but the account holder is expected to pay taxes on the amount of interest earned each year (even though they don’t collect it until they cash out or roll over the CD).

If you’re eager to earn a higher rate on your savings, you’ve got a lot of options to explore — including a high-yield bank account or a regular CD.

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FAQ

What is a coupon on a CD?

The coupon on a CD is its periodic interest payment. When a CD is zero coupon, that means it doesn’t pay out interest monthly or annually. Instead, the investor gets the full amount of interest earned paid out to them when the CD reaches maturity.

Is a certificate of deposit a zero-coupon bond?

Certificates of deposit and bonds are two different types of savings vehicles. While a CD can be zero-coupon the same way that a bond can, your money is not invested in the same way. CD accounts also don’t carry the same types of default risk that bonds can present.

Are CDs safer than bonds?

CDs can be safer than bonds since CDs don’t carry default risk. A bond is only as good as the entity that issues it. If the issuer defaults, then bond investors can lose money. CDs, on the other hand, are issued by banks and typically covered by FDIC insurance which generally makes them safer investments.

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SoFi Bank shall, in its sole discretion, assess each account holder’s 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 a Direct Deposit or $5,000 in Qualifying Deposits to your account, you will begin earning 4.20% 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 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 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 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 Direct Deposit or Qualifying Deposits until you have Direct Deposit activity or $5,000 in Qualifying Deposits in a subsequent 30-Day Evaluation Period. For the avoidance of doubt, an account holder with both Direct Deposit activity and Qualifying Deposits will earn the rates earned by account holders with Direct Deposit.

Members without either Direct Deposit activity or Qualifying Deposits, as determined by SoFi Bank, during a 30-Day Evaluation Period and, if applicable, the grace period, will earn 1.20% 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 10/31/2024. There is no minimum balance requirement. Additional information can be found at https://www.sofi.com/legal/banking-rate-sheet.

Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.

*Awards or rankings from NerdWallet are not indicative of future success or results. This award and its ratings are independently determined and awarded by their respective publications.

SOBK-Q224-1916941-V1

Jun

2024

Guide to Callable Certificates of Deposit (CDs)

By Paulina Likos | Budgeting & Goals, Growing Wealth, money | Comments Off

A callable CD is a certificate of deposit that pays interest like a regular CD, but can be “called” or redeemed by the issuing bank before the maturity date, limiting the return for the investor.

Regular CDs are designed so that investors get back their principal, plus a fixed amount of interest, when the CD matures. But those who own callable CDs may not get the interest they expected if the bank calls the CD early.

Callable CD interest rates tend to be higher because of this potential risk.

What Is a Callable CD?

A callable CD, like a callable bond, means that the bank has the power to terminate the CD before the maturity date. This may happen if there is a drop in interest rates.

For example, if an investor opens a bank account and buys a 2-year callable CD, the bank could close it out as soon as six months after it’s opened, or any time after that, generally at six-month intervals; it depends on the terms of the CD. The investor would then get back their principal and the amount of interest earned up to that point.

It’s important to note that only the issuer has the ability to call the CD early. The investor must leave their money in the CD until it’s called or reaches maturity, or they will likely face an early withdrawal penalty.

How Does a Callable CD Work?

Callable CDs are similar to regular CDs, which are time-deposit accounts offered by banks, credit unions, and brokerages. These accounts provide a fixed interest rate on the funds the account holder has deposited for a specific term (usually a few months to a few years).

Callable CDs generally offer higher interest rates. But unlike a regular CD, a callable CD has a “call” feature which allows the financial institution to decide whether it wants to stop paying the account holder the higher interest rate. This typically occurs when interest rates begin to drop. At that point, the issuer can close out the CD and return the funds to the investor, plus any interest earned up to that point.

The bank typically offers a premium interest rate to account holders in exchange for the risk that the CD might be called.

Callable CD Example

Let’s say an account holder decides to deposit $10,000 into a callable CD that has a three-year maturity with a 5.00% interest rate. The bank, however, decides to call the CD after a year because interest rates dropped, and the bank can now offer CDs at a 4.00% interest rate.

In this case, the account holder would get their $10,000 back along with the interest accrued prior to the bank’s redemption of the CD. That would be about $500 versus more than $1,500 the investor might have earned if they had been able to hold the CD to maturity.

Are Callable CDs FDIC Insured?

Callable CDs, like most types of CDs, are insured up to $250,000 by the Federal Deposit Insurance Corporation (FDIC) or the National Credit Union Association (NCUA) if the CD is issued by a credit union. If there is a bank failure, federal deposit insurance protects the money held in a callable CD up to that amount.

If the CD was issued by a brokerage, which is generally known as a brokered CD, the CD is not technically FDIC-insured. However, the brokerage’s underlying purchase of the CD from a bank typically is FDIC-insured (though it’s a good idea to check to make sure before you open a brokered CD).

Maturity Date vs Callable Date

The maturity date is when the certificate of deposit reaches maturity and the investor can redeem the CD for the principal plus interest accrued during the length of the CD. They can choose to take the earnings or renew the CD.

The callable date is the earliest date at which the CD issuer can close the CD. The first callable date can generally be as soon as six months after the CD was opened, and can typically occur any time after that, at six-month intervals (for example, one year, 18 months, two years, and so on).

Be sure to read the terms of any CD, but especially callable CDs, as the callable date can vary. For example, you could buy a callable CD with a 5-year maturity date and a one-year callable date (the earliest date the issuer can call the CD). That means, at the very least, your money would earn a year’s worth of interest.

Pros of Callable CDs

There are several advantages that may come with opening a callable CD.

• Callable CDs typically pay higher interest rates compared to regular CDs. Since account holders are taking on the risk of the bank redeeming the callable CD prior to its maturity, the account holder gets a higher interest rate in exchange for taking on this risk.

• Like most CDs, callable CDs are generally considered lower-risk investments. If the bank decides to terminate the CD before its term, you will typically still receive the original deposit amount as well as the interest that accumulated until that time.

• In the event of a bank failure, your money is federally insured up to $250,000.

Cons of Callable CDs

While there are positives to callable CDs, these saving vehicles can have some downsides.

• If the account holder needs access to capital and has to withdraw their money prior to the callable CD’s date of maturity, they are subject to early withdrawal penalties which can eat up some or all of the interest earned.

• In the event that interest rates decline, there is a possibility that the bank could call the CD early, in which case the account holder would not receive the same return they would have if the callable CD were to finish its full term.

Where to Open a Callable CD

You can open a callable CD with a bank or credit union, or with some brokerages. The financial institution should be FDIC-insured or National Credit Union Administration-insured so your money is protected.

With a brokered CD, the CD should be insured through the bank the brokerage purchased the CD from, but be sure to check that this is the case before opening the CD.

The Takeaway

If you are looking for investments that are generally lower risk, provide predictable returns, and are protected by federal insurance, callable certificates of deposits might fit the bill. Callable CDs could build your savings by paying a higher fixed interest rate for a specific period of time. However, the account holder takes the risk that the bank might exercise the call option, and close the account before the CD matures.

If you’re interested in earning a higher rate on your savings, you may want to consider other savings vehicles as well, such as a high-yield savings account with a competitive APY that’s higher than the rate offered by traditional savings accounts. Explore the options to choose what best suits your needs.

Better banking is here with SoFi, NerdWallet’s 2024 winner for Best Checking Account Overall.* Enjoy up to 4.20% APY on SoFi Checking and Savings.

FAQ

What is a callable vs a non-callable CD?

Callable CDs are certificates of deposits that pay interest for a specified term like a traditional CD does, but the callable CD rate tends to be higher because the bank can redeem the CD before it reaches maturity. A regular CD does not have a call feature.

Why would a bank call a CD?

Usually, a bank would call a CD in the event of falling interest rates. The bank redeems the CD because with a drop in rates, it can then pay lower rates to its CD holders.

Can you lose money on a callable CD?

Generally, you cannot lose money on a callable CD, but you might get less of a return than you’d hoped. In the event that the CD is called, the account holder receives the principal along with interest that was accumulated up to that point in time, instead of receiving the return for the full term of the CD.

Photo credit: iStock/hallojulie

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® Checking and Savings is offered through SoFi Bank, N.A. ©2024 SoFi Bank, N.A. All rights reserved. Member FDIC. Equal Housing Lender.
The SoFi Bank Debit Mastercard® is issued by SoFi Bank, N.A., pursuant to license by Mastercard International Incorporated and can be used everywhere Mastercard is accepted. Mastercard is a registered trademark, and the circles design is a trademark of Mastercard International Incorporated.

4.20% APY
SoFi members with direct deposit activity can earn 4.20% annual percentage yield (APY) on savings balances (including Vaults) and 0.50% APY on checking balances. 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 (“Direct Deposit”) via the Automated Clearing House (“ACH”) Network during a 30-day Evaluation Period (as defined below). Deposits that are not from an employer 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 Direct Deposit activity. There is no minimum Direct Deposit amount required to qualify for the stated interest rate. SoFi members with direct deposit are eligible for other SoFi Plus benefits.

As an alternative to direct deposit, SoFi members with Qualifying Deposits can earn 4.20% 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 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 a Direct Deposit or $5,000 in Qualifying Deposits to your account, you will begin earning 4.20% 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 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 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 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 Direct Deposit or Qualifying Deposits until you have Direct Deposit activity or $5,000 in Qualifying Deposits in a subsequent 30-Day Evaluation Period. For the avoidance of doubt, an account holder with both Direct Deposit activity and Qualifying Deposits will earn the rates earned by account holders with Direct Deposit.

Members without either Direct Deposit activity or Qualifying Deposits, as determined by SoFi Bank, during a 30-Day Evaluation Period and, if applicable, the grace period, will earn 1.20% 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 10/31/2024. There is no minimum balance requirement. Additional information can be found at https://www.sofi.com/legal/banking-rate-sheet.

*Awards or rankings from NerdWallet are not indicative of future success or results. This award and its ratings are independently determined and awarded by their respective publications.

SOBK-Q224-1916985-V1

Jun

2024

Banker’s Acceptance (BA): Definition, How It Works, Uses

By Mike Zaccardi, CMT, CFA | money, Terminology | Comments Off

A banker’s acceptance (or BA) is a financial instrument used to guarantee large future transactions, often in the import/export markets. As a debt instrument, it can function as an investment, commonly traded between large banks and institutional investors on the secondary market. It can trade at a discount to par like U.S. Treasury bills in money markets.

BAs play a key role in facilitating international trade and in broader fixed-income markets. While you may not own an individual banker’s acceptance in your checking account, these instruments help promote sound and liquid markets.

What Is Banker’s Acceptance?

A banker’s acceptance (which you may see written as bankers acceptance) is a short-term form of payment guaranteed by a bank; it is often used for international trade transactions.

Banks often make money on the spread between the buy and sell price on a fixed-income asset or through fees and commissions. BAs commonly have a maturity of between 30 and 180 days and trade at a discount to par. Functioning like a post-dated check, they are seen as a relatively safe method of payment for large transactions. BAs are considered short-term debt instruments.

Here are some more details about banker’s acceptance and how these instruments work.

• The BA is issued and priced based on the creditworthiness of the issuing bank. An investment banker earns a commission for making the transaction.

• Only customers with a strong credit history can access the BA market. These entities are often corporations involved in international trading (import/export) markets.

• A banker’s acceptance can also be highly marketable and liquid, allowing money to transfer from one bank to another.

💡 Quick Tip: Help your money earn more money! Opening a bank account online often gets you higher-than-average rates.

How Banker’s Acceptance Works

A banker’s acceptance is considered a time draft. A business can request one from a bank as a way of gaining enhanced security while conducting a deal. The bank essentially promises to pay the firm that is exporting goods a particular amount of money on a certain date. When it does this, it takes funds out of the importer’s bank account.

Typically, the term of a banker’s acceptance is between 30 and 180 days.

Who Issues Banker’s Acceptance?

Not all banks offer BAs. Businesses with a good relationship with a large bank can obtain a banker’s acceptance. It can be an appealing product for an institution entering a large-value transaction. Like signing a check over to someone, the account holder must have enough cash to execute the transaction.

More than a simple checking account transaction, though, obtaining a BA typically requires an amount of credit to be detailed. There are usually fees involved in obtaining a BA, too.

Who Buys Banker’s Acceptances?

Banker’s acceptances are traded by banks and securities dealers on a secondary market, similar to how debt instruments are traded. They are available for a discount on its face value. The exact value may vary with the rating of the bank that has promised payment on the banker’s acceptance.

How Banker’s Acceptance Is Used

Here’s more detail on how banker’s acceptances can be used.

Checks

Think of a banker’s acceptance as a certified check. It’s a relatively safe way to do a transaction. The money owed is guaranteed on a specific date listed on the BA bill. Credit analysis is usually done to verify the creditworthiness of the issuer, so it’s a bit different than how a bank will verify a check before you deposit it.

BAs are frequently used to facilitate the international trading of goods. A buyer of imported products can issue a BA with a payment date after a shipment is scheduled to be delivered. The seller exporting can then take payment before finalizing the shipment. The exporter in this case can hold the BA to maturity or sell it on the secondary market. Unlike a check, the BA is backed by the guarantee of the bank, not an individual.

Investments

Aside from the import/export market, bankers’ acceptances are used commonly in the investment world. Buyers might purchase a BA and hold it to maturity to effectively earn a rate of return on short-term money. Since BAs are seen as very low-risk products, they are used as a cash-like security.

Still, retail consumers usually won’t be able to purchase a BA in an online or traditional retail bank. The purchase is, as noted above, only available to certain financial entities.

Pros and Cons of Banker’s Acceptance

There are a number of positive aspects of bankers’ acceptances to consider.

Pros

First, the upsides of BAs:

Provides Seller Assurances Against Default

Backed by the guarantee of a bank, a banker’s acceptance is regarded as a high-quality fixed-income security that is often liquid and highly marketable. For importers and exporters, financial transactions can be made to facilitate international trading of goods without the risk that one party goes bust.

Buyer Does Not Have to Prepay for Goods

A banker’s acceptance works like a promissory note so the buyer does not have to prepay. Liability can immediately transfer from the issuer of the banker’s acceptance to the bank. The payment is likely debited only on the due date.

Enhances Confidence in the Deal

Part of the process of issuing a banker’s acceptance is usually having a good credit standing and a relationship with a major bank. Since high-risk customers might not be considered, there is strong confidence in BAs traded. There would be no need for the exporting company to worry about default risk; that lies with the banker. While individual investors often do not engage in BA trading, there are important traditional banking alternatives that feature financial solutions to help facilitate transactions.

Cons

While there are many positive aspects of bankers’ acceptances, there are still some risks for those involved in the transaction and trading of BAs. Consider the following:

Bank May Require Buyer to Post Collateral to Hedge Risk

Collateral is sometimes required for a deal to happen. Collateral provides a backstop should the importer be unable to pay. It can reduce risks to the bank and expedite the deal. Think of it like seller concessions to get a deal done, though collateral is generally not used when buying and selling a home.

Buyer May Default

With a banker’s acceptance, the bank accepts default risk, which can be a downside. The issuing bank typically must honor the payment terms even if the account holder, perhaps an importing/exporting corporation, does not have the cash on the payment date. Not all banks choose to be in this market due to the risk that the buyer could default.

Potential Liquidity Risk

Liquidity risk means an individual or financial institution cannot meet its debt obligations in the short term. Investors may not encounter liquidity risk with a banker’s acceptance instrument, but the issuing bank could have liquidity risk from the importer who must pay. This may be a key consideration for a bank issuing a BA. The secondary market for banker’s acceptance products remains highly liquid.

Pros of BAs	Cons of BAs
Provides assurance vs. default	Bank may require collateral
Buyer doesn’t need to prepay for goods	Buyer may default
Enhances confidence that deal will work	Potential liquidity risk

The Takeaway

A banker’s acceptance is a debt instrument that plays a key role in well-functioning capital markets. BAs help facilitate international trade through bank guarantees. Knowing about this important fixed-income product type can help individuals understand financial markets and institutions.

When it’s time to take a look at your personal banking partner, it can pay to shop around for the right fit.

Better banking is here with SoFi, NerdWallet’s 2024 winner for Best Checking Account Overall.* Enjoy up to 4.20% APY on SoFi Checking and Savings.

FAQ

What is the difference between a letter of credit and a banker’s acceptance?

A letter of credit is a financial instrument that a bank issues for a buyer (the bank client) guaranteeing that a seller will be paid. A banker’s acceptance, on the other hand, guarantees that the bank will pay for a future transaction, rather than the individual account holder.

What is a banker’s acceptance in a real-life example?

An example of a banker’s acceptance would be that, on April 1st, the Acme Bank sends a BA to Back-to-School Supplies, saying it will make funds available on June 1st for a shipment of goods for their client. On June 1st, the school supply company will be able to withdraw those funds.

How safe are banker’s acceptances?

Banker’s acceptances are a relatively safe transaction for all involved, but the exact degree will vary with the creditworthiness of the bank guaranteeing the funds.

Is a banker’s acceptance a short-term investment?

Banker’s acceptances are considered a short-term investment or debt instrument. They are usually traded at a discount, and they are seen as similar to Treasury bills.

Is a banker’s acceptance a loan?

A banker’s acceptance isn’t a loan. It’s a short-term debt instrument, typically with a maturity date of 30 to 180 days.

Photo credit: iStock/Deagreez

SoFi® Checking and Savings is offered through SoFi Bank, N.A. ©2024 SoFi Bank, N.A. All rights reserved. Member FDIC. Equal Housing Lender.
The SoFi Bank Debit Mastercard® is issued by SoFi Bank, N.A., pursuant to license by Mastercard International Incorporated and can be used everywhere Mastercard is accepted. Mastercard is a registered trademark, and the circles design is a trademark of Mastercard International Incorporated.

SoFi members with direct deposit activity can earn 4.20% annual percentage yield (APY) on savings balances (including Vaults) and 0.50% APY on checking balances. 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 (“Direct Deposit”) via the Automated Clearing House (“ACH”) Network during a 30-day Evaluation Period (as defined below). Deposits that are not from an employer 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 Direct Deposit activity. There is no minimum Direct Deposit amount required to qualify for the stated interest rate. SoFi members with direct deposit are eligible for other SoFi Plus benefits.

As an alternative to direct deposit, SoFi members with Qualifying Deposits can earn 4.20% 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 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 a Direct Deposit or $5,000 in Qualifying Deposits to your account, you will begin earning 4.20% 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 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 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 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 Direct Deposit or Qualifying Deposits until you have Direct Deposit activity or $5,000 in Qualifying Deposits in a subsequent 30-Day Evaluation Period. For the avoidance of doubt, an account holder with both Direct Deposit activity and Qualifying Deposits will earn the rates earned by account holders with Direct Deposit.

Members without either Direct Deposit activity or Qualifying Deposits, as determined by SoFi Bank, during a 30-Day Evaluation Period and, if applicable, the grace period, will earn 1.20% 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 10/31/2024. There is no minimum balance requirement. Additional information can be found at https://www.sofi.com/legal/banking-rate-sheet.

*Awards or rankings from NerdWallet are not indicative of future success or results. This award and its ratings are independently determined and awarded by their respective publications.

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.

SOBK-Q224-1920309-V1

Jun

2024

Bank Guarantees: What You Need to Know

By Timothy Moore | Life & Career, money | Comments Off

A bank guarantee is a promise by a financial institution that it will assume liability for a business contract if one party fails to uphold its obligation to another. In this way, the bank acts like a cosigner for a buyer or borrower on a business agreement, reducing the risk for the seller or lender.

This can be a valuable assurance for organizations that are conducting financial transactions. For a small fee, bank guarantees often enable small businesses to enter into contracts with larger companies with which they otherwise would not be able to do business. Read on to learn more about how bank guarantees work and their pros and cons.

What Is a Bank Guarantee?

A bank guarantee promises that, if one party in a business agreement fails to meet its obligations, the bank will cover its debts. By backing up a transaction, it adds confidence to riskier deals.

Bank guarantees involve a thorough review of the business applicant’s finances and credentials. If, after this due diligence, a commercial bank feels confident that an applicant (the debtor) will be able to uphold their contractual obligations, the bank may offer the guarantee to the other party (the beneficiary). This can lead to greater assurance that the transaction will go smoothly.

Bank guarantees are usually a part of more complex financial transactions between businesses. The average borrower won’t need to worry about bank guarantees for auto loans, mortgages, or personal loans.

A little more detail on bank guarantees for business clients of a financial institution:

• Companies often use bank guarantees for complicated contracts involving goods and services. If a vendor fails to provide goods or services that have already been paid for, a bank guarantee ensures reimbursement for the business using that vendor.

If, on the other hand, a buyer fails to pay for goods or services that have already been delivered or rendered, the bank guarantee covers the unpaid balance for the seller.

• Because a bank guarantee might protect a buyer or a seller, it may be easier to think of them in terms of the beneficiary (the company that requires a bank guarantee to feel protected and move forward with a contract) and an applicant (the company that must apply for the bank guarantee to close the deal).

💡 Quick Tip: An online bank account with SoFi can help your money earn more — up to 4.20% APY, with no minimum balance required.

How Do Bank Guarantees Work?

If a contract includes a bank guarantee, that guarantee will specify an amount to be repaid (or the goods or services to be delivered) and a set timeframe in which the transaction will happen. The contract will also spell out the bank’s responsibility should the applicant fail to meet their contractual obligations.

To assume this risk, banks charge applicants a fee for the guarantee, expressed as a percentage of the cost or value of the transaction, typically around 0.5% to 1.5%.

If the bank deems a contract particularly risky, it might require the applicant to offer collateral. Unlike with secured personal loans, where a house or car might serve as collateral, bank guarantee collateral is typically liquid assets, like stocks or bonds.

Types of Bank Guarantees

There are two main types of bank guarantees: financial bank guarantees and performance guarantees.

Financial Bank Guarantee

With a financial bank guarantee, a bank promises to repay a debt if the borrower (or buyer) defaults on the agreement. For example, an applicant may purchase goods and services from a large company, receive said goods and services, and never pay the bill. In this instance, the bank would settle the debt with the large company since the funds can’t come out of the borrower’s bank account.

What Is a Performance Guarantee?

In this situation, if an applicant fails to perform the obligations laid out in contract (e.g., supplying parts to a company), the beneficiary can make a claim with the bank for the losses incurred from the non-performance of contractual obligations.

Performance failure might also mean that, though the goods or services were delivered, they did not meet quality standards specified in the contract. In these situations, the bank would step in to offset those losses.

Examples of Bank Guarantees

Bank guarantees can serve many purposes, usually between two businesses. Here are a few of the guarantees that banks often issue:

Rental Guarantee

A rental guarantee protects a landlord when entering into a contract with a company (like a restaurant or retailer) that wants to lease a space. This guarantee serves as collateral for a rental lease.

Advanced Payment Guarantee

An advanced guarantee protects a company that has paid in advance for goods or services that weren’t delivered. You may also hear this referred to as a cash guarantee. If the deal isn’t satisfied, the company that has paid out in advance will be refunded.

Performance Bond Guarantee

A performance bond is a kind of financial guarantee for a business deal, to protect against one party failing to meet its obligations. You may also hear this called a contract bond. If, say, a contractor doesn’t complete the work they agreed to do, a performance bond guarantee can protect the party paying for the project. That entity would be compensated for their loss.

Warranty Bond Guarantee

When a bank provides a warranty bond guarantee, that protects the buyer in a transaction, ensuring that goods are delivered as specified. This could refer to the quality and condition of the items as well as the timing of their arrival.

You may also hear this term used in another situation. Sometimes referred to as a maintenance bond, a warranty bond guarantee can be a financial guarantee in which a builder promises to protect the owner of a construction project from problems with workmanship or faults with materials that could occur after the project’s completion. A financial institution or insurer will back up this promise.

Payment Guarantee

A payment guarantee is quite simply what it sounds like: It guarantees that, if, say, a buyer fails to send adequate funds for a purchase, the bank will step in and cover the shortfall. It allows a seller to feel confident that they will be paid in full on a predetermined date.

Pros and Cons of Bank Guarantees

Here’s what you need to know about the upsides and downsides of bank guarantees.

Pros

Among the most important advantages or a bank guarantee are the following:

• Reduced costs: While not free, a bank guarantee can be a cost-effective way to encourage confidence and help a deal go through. It may be less expensive to obtain, say, than taking out a small business loan to cover a potential debt.

• Reduced risk: A bank guarantee reduces risk since the bank promises to pay if one party doesn’t hold up their end of the deal. In this way, a bank guarantee can open up new opportunities for businesses, especially those without a long or solid credit history.

• Quick activation: It typically takes only a few days to obtain a bank guarantee.

• Enhanced credibility: Before offering a guarantee, a bank does a comprehensive assessment of an applicant’s financial standing. Earning a bank’s backing through a guarantee demonstrates that the bank finds the applicant company to be credible.

Cons

Next, the potential drawbacks of bank guarantees to be aware of:

• Stringent approval guidelines: Bank guarantees aren’t given to just any entity. A business must show that it merits this backing. Not every applicant will qualify.

• Collateral requirement: If a venture seems particularly risky, banks may require collateral from applicants; this can be risky for startups with limited funding.

• Complex regulations: There have been scams involving bank guarantees in some international transactions. Using a bank guarantee for an international deal may therefore require many complex steps and assurances before it moves forward.

The Takeaway

In business transactions, a bank guarantee promises that the financial institution will cover any debts to one party if the other party does not meet its obligations. Larger companies often require small businesses and startups to obtain a bank guarantee before doing business with them. These guarantees can help a small or new business secure large deals since the bank has shown confidence in them.

That said, if you’re focused on your personal finances and are considering your options, see what SoFi offers.

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FAQ

What is the difference between bank guarantees and letters of credit?

Both bank guarantees and letters of credit add confidence to business deals, with slight differences. With a bank guarantee, the financial institution promises to step in and pay debts, if needed, for the party they guaranteed. A letter of credit, useful in international trade, substitutes the bank’s credit for a business’. The bank will guarantee payment if the business defaults on their obligation, but only once certain criteria are met.

What is the purpose of a bank guarantee?

The purpose of a bank guarantee is to add confidence to a contract between two parties. If one party fails to uphold its contractual obligations or defaults on a loan, the bank promises to step in and uphold the contract and pay the debt that may result.

How can I get a bank guarantee?

If a business is requiring a bank guarantee to enter into a contract, contact your bank (or your business’ bank) and request an application. The bank will then review the completed application to determine your creditworthiness, typically within a few business days.

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