Is this hot CD right for you?

August 18, 2006

Floating-rate CDs reward you on the upside and protect you on the downside. But heed these caveats.

Say you just decided to plunk down some extra cash in a CD. On your way into the bank, you notice its advertisement for a new "floating-rate" CD. Intrigued, you inquire within and end up leaving the bank more mystified than when you entered.

You're not alone in your confusion. Certificates of deposit are traditionally thought of as one of the most straightforward methods of growing your money, albeit at a modest rate. But multiple variations on the theme have made them look more like hedge funds. Here's what you need to know about some of these tricky investments, available through brokers as well as banks.

What's available

Consider, for instance, the five-year CD linked to the Dow Jones Industrial Average recently offered by Piscataqua Savings Bank in Portsmouth, NH. It's typical of these offerings. The CD allows investors to benefit from any rise in the average, and also guarantees return of principal in a down market-but only if you hold the CD to maturity.

A few complications: While you benefit if the market goes up, you don't receive as much as if you'd invested outright in the DJIA, through an index or exchange-traded fund. Because the CD's so-called participation rate is only 85 percent, you lose out on 15 percent of the market's gain. So if the market went up 15 percent, say, your rate would rise by only 12.75 percent. Also, "a large component of your return in the stock market is dividends, and the ability to reinvest them," points out Greg McBride of Bankrate.com, a personal finance website. "But dividends aren't included in these CDs."

And comparison-shopping can be tricky. Since the interest on this CD is determined at maturity, there's no quoted yield to compare the CD to other investments. That's certainly the case with gold-linked CDs, which have no stated interest rate because they're tied to the price of gold over the term of the CD. EverBank's MarketSafe Gold Bullion CDs' rate of return is calculated at the end of its five-year term, and is dependent on 10 semiannual spot prices of gold bullion during that time frame. All principal is guaranteed, but don't even think about getting your money out early. Only on death or judgment of incompetence can you do so.

Other drawbacks of floating CDs: Some have caps on how much you can earn. Washington Mutual currently has a 6 percent cap on its 36-month Indexed CD, whose variable rate is tied to the three-month Treasury bill. In addition, terms for indexed CDs tend to be longer than for traditional CDs, and the early withdrawal penalties can be stiffer. For example, if you invest in the seven-year version of Washington Mutual's Indexed CD and take your money out after five, you'll be charged a full year of interest, at the current rate, on the amount you withdraw.

Bank or broker?

Many of these specialized CDs are available through brokers as well as banks. The difference is that brokered CDs often pay a higher yield because they benefit from economies of scale. These CDs normally won't cost you any fee or commission because the bank compensates the broker, who will hold the CD certificate for you, and provide you with account statements and tax information.

The potential downside of brokered CDs comes when you want to cash out early. You usually can't opt for early withdrawal except in the case of death or incompetence, but you can sell your CD. Brokered CDs are traded on the secondary market, though, so your selling price will be at the whim of the market. In the worst-case scenario, you could end up losing principal, so be sure you can commit for the term of the CD before considering it.