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Beware of Risk With Variable-Rate CDs

By sbup Staff
One of the biggest attractions of certificates of deposit (CDs) is that they offer a safe way to grow your savings without worrying about market fluctuations. A conventional CD offers a fixed interest rate that remains constant for the duration of the CD’s term. When you invest in a conventional fixed-rate CD, you know exactly how much you will have when the CD matures.

But one disadvantage with a fixed-rate CD, however, is that you’re locked into that rate for the full term. If interest rates rise, you won’t be able to take advantage.

There are some choices though. Variable-rate CDs are designed to address this disadvantage, but those investments aren’t risk-free. With a variable-rate CD, the interest rate can change during the product’s term. If interest rates rise, the CD's interest rate will rise as well. Unfortunately, the converse is also true.

Variable-rate CDs are structured differently from bank to bank. Some banks utilize a “multi-step” structure, which adjusts interest rates in accordance with a pre-determined schedule. These CDs are often tied to U.S. Treasury Note rates. Other banks offer variable-rate CDs that track a common interest index, such as the Dow Jones Industrial Average (DJIA). There may be restrictions on how many times the interest rate can be changed, however.

PNC Bank (Stock Quote: PNC), for example, offers a 18-month variable rate CD with a rate tied to the 3-month Treasury Bill, which changes quarterly. Capital One’s (Stock Quote: COF) Treasury Plus Indexed CD changes its rate every Wednesday, with rates tied to the 90-Day T-Bill auction discount rate, plus an extra 0.25%.

When you choose to buy a variable-rate CD, you're betting on interest rates going up. In this volatile economy, it is practically impossible to predict exactly how interest rates will behave in the future, but the current trend is downward. Customers who bought variable-rate CDs a year ago before the bank collapse have likely seen their interest rates fall considerably. Had they chosen a fixed-rate CD, their investment would have been mostly unaffected by the economic downturn.

Most banks offer a guaranteed return on principal for variable-rate CDs (when held to maturity), which protects customers from actually losing money in a down market. If your money is locked into a CD with a falling interest rate, however, it could be costing you money in other missed investments and inflation. Taking your money out of a CD early will also cost you dearly. In some cases, you can lose all of the interest you have earned to date plus interest that has yet to accrue. That means you could end up forfeiting a portion of your principal if you make an early withdrawal. Early withdrawal penalties for variable-rate CDs tend to be harsher than with conventional CDs.

Variable-rate CDs are a way for investors to inject an element of risk into their personal finances without the fear of losing big. Unlike stock investing, there is virtually no risk to the principal if a CD is allowed to mature. In the current economic situation, however, buying a variable-rate CD is certainly a gamble. If you think interest rates are going to rebound, a bump-up CD, which allows you to take advantage of a higher interest rate once during the term of the CD, may be a safer option. Bank of America (Stock Quote: BAC) offers a “Opt-Up” CD with these features.

manybanking.com's CD Section lets you browse CD rates and offers in our area. Since variable-rate CDs are not quite as popular as the fixed-rate options, you might have to contact a bank directly, or investigate its website, to find these type of products.

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