A certificate of deposit, or CD, is provided by a bank or credit union and is known as a time deposit, meaning once you invest money it has to stay there for a predetermined length of time to build interest. Most CDs are standard fixed-rate CDs and they accumulate a constant rate of interest throughout the term of the CD. Regardless of what happens with the market rates, whether they increase or decrease, the rate of interest on the CD will remain the same until the maturity date (time the term ends).
But lately there has been a slump of low rates on standard CDs, and banks and lenders are beginning to think outside of the box to encourage customers. A new series of nontraditional CDs are becoming popular, and they are anything but fixed-rate. Indexed CDs, also known as variable-rate CDs, are a type of CD whose rates are indexed to the rates of something else. Generally they are indexed to a stock index like the S&P 500 or the Dow Jones Industrial Average, but they can also be indexed to other things like bonds, commodities prices, and foreign currency.
Banks and lending institutions are also now offering hybrid CDs, which are similar to indexed CDs in their flexibility but have some other differences. Two examples of hybrid CDs are the step-up CD and bump-up CD. With a step-up CD your interest rate takes a step up (increases) in predetermined intervals throughout the duration of the term. With a bump-up CD the investor has a limited ability to, when the market rates are higher, bump up the CD rate to match the market. Another advantage to the step-up CD is that you can compute what your accumulated rate will be at the end of the CD and compare that to fixed-rate CDs, whereas with indexed CDs and bump-up CDs you have to wait until the maturity date to see exactly what your return is.
Risks and Rewards
Indexed and hybrid CDs are great because they give investors flexibility, more control, and a chance to participate in the market and possibly earn higher rates of interest on the CD. At the same time, if market rates go the opposite way and decrease then the principle on the CD is still protected and left untouched. Another perk is that these nontraditional CDs are offered by banks, which means they fall under the Federal Deposit Insurance Corp’s insurance coverage of up to $250,000.
One of the downsides to hybrid and variable-rate CDs is that if market rates decrease then you might not earn as much interest on your invest as you would with a standard CD. But the biggest drawback is the complex nature of these CDs and the many varying terms and conditions investors have to figure out and remember. For instance, the manner in which returns are calculated can differ widely between banks. Your return may be measured in a variety of ways, such as by a one-to-one on the index’s appreciation, a participation rate, a point-to-point system, and by the quarterly averages of the market. Some people think they are getting a fantastic deal, but they might not actually understand the fine print and they might end up with less than they had planned. So be sure you understand every detail and term before investing in one of these CDs.