Alternative CDs offer higher rates, risks
By Sandra Block
When President Franklin Roosevelt signed the Banking Act of 1933, he had wanted to restore confidence in the nation's banking system. Since then, no saver has lost a dime in federally insured deposits.
But much has changed in the past 75 years. The types of accounts eligible for deposit insurance have grown increasingly complex.
This is particularly the case with certificates of deposit. With a conventional CD, you receive a set interest rate for a specific period, typically three months to five years. As long as you don't withdraw your money before the CD matures, you get back your principal and all the interest. But safety comes at a price. The average one-year CD is yielding a puny 2.15 percent, according to Bankrate.com. The average rate for a five-year CD is just 3.16 percent.
There are alternatives for investors who would like to earn higher interest rates without sacrificing deposit insurance. But you need to understand the risks. Here's a look at some of the non-traditional CDs, along with the downsides:
Drawbacks: To get the bump-up option, you'll probably have to accept a lower initial rate than standard CDs are paying. So if rates don't rise, you're stuck with a CD that pays a below-average rate. And even if rates start moving up, figuring out when to request an increase is tricky, McBride says. Pull the trigger too soon, and you could miss out on an even higher rate. But if you wait too long, he says, you might not have enough time to benefit from the higher rate before your CD matures.
Drawbacks: With callable CDs, the banks hold all the cards, McBride says. If rates drop before your CD matures, there's a good chance your bank will exercise its call option. You'll get back all your principal and the interest you've earned. But if you want to reinvest the money, you'll have to reinvest it at the new, lower rates.
But what if rates rise? Too bad, because you don't get a call option. You'll have two options, both of them unappealing: Hold onto a CD with a below-market rate, or cash it in before maturity and pay a hefty penalty.
Drawbacks: If your broker invests your money in a bank where you already have insured deposits, you could inadvertently end up exceeding the federal deposit insurance limit of $100,000. FDIC Chairman Sheila Bair says a good broker will make sure you stay under the limit for insured deposits.
In fact, when the FDIC takes over a bank, "Our goal is to make sure they (depositors) have their money by the next business day," Bair says. "We almost always meet that goal."
