A reader named John wrote in with the following question about what happens to a certificates of deposit (CDs) when a bank fails:
If a customer has a CD at a bank that fails, is there a risk that the account will stop earning interest until assets are purchased by another institution, or when the other bank takes over may it change the interest rate on the CD?
When a bank fails, the FDIC typically transfers the dead bank’s deposits to a new bank in fairly short order. Thus, unless you have a “brokered” CD (more on this below), there’s not much risk of extended downtime. It’s also worth noting that federal law requires the FDIC to pay 100% of your deposits up to FDIC insurance limits, including both principal and interest.
While the interest that you’ve earned to date is safe (assuming you’ve respected the FDIC limits), it’s quite possible that your rate will change. The reason for this is that the new bank isn’t required to honor the terms of the failed institution’s deposit agreements. The good news is that you’re not subject to early withdrawal penalties if you don’t like the new terms.
Two examples of CDs at failed banks
When NetBank failed in the fall of 2007, their deposits were transferred to ING Direct. In contrast, when the FDIC takeover of IndyMac Bank and turned it into IndyMac Federal Bank, they maintained the high CD rates that were being offered just before IndyMac’s failure.
Be careful with brokered CDs
As noted above, the situation is a bit different for “brokered” CDs, which are purchased through a third-party (such as a brokerage firm) instead of directly from a bank. In this case, the CDs are rarely passed directly to the new bank. Instead, the funds typically get wired back to the broker. This can take some time, however, as the FDIC has to first cross-reference the owners of the brokered CDs against the list of depositors at the bank to ensure that they don’t have other deposits at the bank that might push them over the FDIC insurance limits.
This brings up another point about brokered CDs… If you’re thinking about buying one, be sure you know where the broker plans to deposit your money. Otherwise, depending on the size of the CD and the amount of money you already have at a given bank, you might end up inadvertently exceed the FDIC insurance limits.