||Ask Dr. Don
Avoid being long and wrong
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?
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.
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