No Way Am I Opening This 12-Month CD, Even Though Its Rate Is 5.92%

Right now, many 12-month certificates of deposit (CDs) have rates above 5%, with the most competitive rates hovering around 5.40%. But recently I came across a 12-month CD with an astonishing 5.92% interest rate. The CD is offered by Merchants Bank of Indiana and comes in three terms. At first I was skeptical. Then, when I read the fine print, I realized what kind of CD this was -- and knew immediately I wasn't going to open it. Here's what I discovered.

The CD from Merchants Bank is a "flex CD"

Most of us are familiar with how traditional CDs work. You agree to leave your money with a bank for a set period, and in exchange for the limited accessibility, the bank gives you a fixed interest rate.

Flex CDs work differently. The CD still has a term, but instead of a fixed interest rate, your CD rate is variable. Most flex CDs track an underlying index, so when the index changes, so does the CD's rate.

For example, the rate on the Flex CD from Merchants Bank is determined by a prime rate index, which itself keeps pace with the federal fund rate. There's also a margin of 2.75%, which is subtracted from whatever the prime rate index. It also has a floor of 0%, meaning you won't lose money in the CD.

This flex CD benefits savers when the Fed raises rates. But even without a rate hike, it can still boast one of the best CD rates on the market -- 5.92%. What's more, this rate will likely stay as-is for at least as long as the Federal Reserve keeps its fund rate the same.

The problem: The fund rate may not stay the same

While this CD could benefit you if the Fed raised rates, that's not likely to happen. In fact, the opposite could occur: The Fed could very well start lowering rates as soon as this year.

To be sure, there's not enough economic data to predict how soon the central bank will begin reducing rates. While many experts predicted at least three rate cuts in 2024, recent inflation data has suggested the Federal Reserve may have more fight before rates start to go down.

The April jobs report showed that hiring and wage growth rose by a much slower pace than expected, which is exactly what the Federal Reserve wants. While the last CPI report wasn't too encouraging, a slightly weaker labor market could indicate the economy is slowing down. If it plays out that way in future economic data, the Federal Reserve might finally feel comfortable reducing rates.

If the Federal Reserve didn't hike rates in 2024, the most a flex CD holder could hope for is continued rate pauses. This, at least, has been the case so far this year. However, since the central bank aims to reduce the federal fund rate after stoking inflation, you're certainly taking a risk investing in a CD whose rate will drop if the Fed rate does.

Again, 5.92% is great if it stays that way for the length of your term. But given the current interest rate forecast, opening a CD with a variable rate is risky. While it could bring greater returns if the Fed raises rates, it could also backfire if the Federal Reserve started reducing rates faster than expected. It might play a role in diversifying your CD strategy, allowing you to capture rising rates in a way your other CDs can't. But if you're looking to invest in one or two CDs, a traditional CD might serve you better.

On that note, Merchants Bank has some good short-term CD offerings. Its 3-month, 6-month, and 12-month CDs have 5.25% APYs, which are fixed for the length of those terms. If you don't want to risk a rate reduction in your CD, these could be better choices. Take a look at these and other great CD options and see if guaranteed returns might serve you better.