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Ask Dr. Don
Bankrate.com

Avoid being long and wrong with CDs

Dear Dr. Don,
Would it be wise to lock into a five-year CD (certificate of deposit) with rates above 5 percent or should I wait for a while?
Charles Certificate

Dear Charles,
Bankrate's CD Rate Trend Index comes out weekly with its survey results on where investment professionals think interest rates are heading. It's a great way to keep up with the trends in interest rates. You can also use Bankrate to shop for the highest CD rates in your region or the nation with its Best Rates search feature.

Investing in a standard five-year CD means that you've locked in that interest rate for the next five years. You want to avoid being long and wrong, committing to a long-term deposit only to watch interest rates head higher.

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If you're uncertain about where long-term rates are headed, there are a couple of ways to manage this risk. One way is by investing in a bump up CD. Another way is by building a laddered CD portfolio. A third way is by investing in a callable CD, but I'm not going to recommend that you pursue that option.

A bump-up CD allows you to participate in higher interest rates by having the bank bump up your rate. The typical bump-up CD only allows the depositor to do this once, and often the window to make this decision is limited to early on in the investment term.

If you are worried about interest-rate fluctuations you will be much better off investing in a laddered CD portfolio than trying to guess where interest rates are heading. See Laura Bruce's reporting on "How to ladder a CD portfolio" for all the details.

Here's what I don't like about consumers buying callable CDs. If interest rates go lower, the CD gets called away and the investor has to reinvest in a lower interest rate environment. Conversely, if interest rates go higher, the investor is long and wrong and the only compensation for that is an additional quarter- to half-percentage point in yield from the callable CD.

So the investor loses if interest rates go down because the CD is called away and loses if interest rates go up because it's not. The bank is giving you a heads I win, tails you lose proposition. Don't take it.

-- Posted: Feb. 11, 2002

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See Also
How to ladder a CD portfolio
CD 'early withdrawal penalties' explained
More Dr. Don stories

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