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4 caveats on variable-rate CDs

Variable-rate certificates of deposit (CDs) are nothing new, but they may seem like an especially appealing concept in today's low-interest-rate environment. However, the numbers behind these products don't always add up to a good deal for savers.

While most CD rates are fixed for the length of the term, variable-rate CDs have interest rates that can change, either according to a prearranged formula based on some index, or at the customer's option when rates rise. A couple of factors make these accounts seem unusually compelling today:
  1. CD rates are extremely low. According to recent FDIC figures, the average rate for a one-month CD is just 0.05 percent, even lower than the average for savings accounts and money market accounts.
  2. The time premium has all but disappeared. If you are willing to commit to a longer term CD, you are generally compensated for that commitment with a higher rate. However, this premium for longer commitments has shrunk considerably. Five years ago, five-year CDs were paying about 2 percent more than savings accounts. Now, they pay less than 70 basis points more.

Both of the above conditions are pretty unusual, so a variable-rate CD can be a way of making sure you do not find yourself locked into low rates after more normal conditions have returned.

The trouble with variable-rate CDs

Unfortunately, though the idea of flexibility sounds good right now, the numbers offered on variable-rate CDs don't necessarily add up in your favor. Here are four reasons why:
  1. You will probably pay a price for the option. CDs that give you the option of a "bump-up" in rates if yields rise before the CD term expires generally make you pay for that option in the form of a lower initial rate. When you compare these rates with standard CD rates, you may conclude that the option is not worth the price.
  2. It might be cheaper to pay an early withdrawal penalty. It depends on the size of the penalty of course, but in some cases the early-withdrawal penalty on a CD represents just a few months' interest. That may turn out to be less than the cut in rates you would get on a bump-up CD, and you would only pay the price if rate changes made it worthwhile.
  3. The bump-up option has less value as time goes on. If you do accept a lower initial rate, keep in mind that the longer it takes for rates to rise, the less valuable the bump-up option becomes. The more time goes by, the longer you are stuck in a substandard rate, and the less remaining time you will have to benefit from a rate bump.
  4. Losing ground to inflation is as bad as losing money. Indexed CDs may tout the fact that your principal is guaranteed, so the worst that can happen is that you will earn no interest if the index does not move in your favor. However, earning no interest while inflation creeps forward is effectively the same as losing money.

Most types of financial instruments are not inherently good or bad -- it is the specific terms that determine how favorable they are. So if you consider a variable-rate CD, do not just fall for the idea behind the product. Make sure that the numbers allow that idea to work for you.

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