CDs that sound too good to be true

Walter Updegrave is a senior editor with Money Magazine and is the author of "How to Retire Rich in a Totally Changed World: Why You're Not in Kansas Anymore" (Three Rivers Press 2005).

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NEW YORK (Money) -- Question: I have $12,000 I want to invest for the short term. Banks are offering 2% annual percentage yields at best for three-month CDs, but I've seen an ad by a financial institution in my area for a three-month CD that pays 8%. This firm isn't a bank, but it says the CD is FDIC insured. Are you familiar with this type of CD? Do you think it's safe? --David Ankley, Leesburg, Florida

Answer: If the events of the past year have taught us anything, it's that you've got to be extremely skeptical about putting your money into any investment or venture when the upside looks too good to be true.

Remember all those investment banks that bought subprime mortgage securities that they felt were secure because a ratings firm slapped triple-A credit ratings on them? That didn't work out so well for them (or us, for that matter).

We've also had a couple of cautionary tales on the personal investing front recently. First, there's the still-ongoing saga of the Madoff affair, which hinged on people accepting the premise that Bernie Madoff had a magical investing system that allowed him to churn out returns of 10% to 12% like clockwork.

And not long after the curtain had been pulled back on good old uncle Bernie's alleged $50 billion Ponzi scheme, the Securities and Exchange Commission charged philanthropist/cricket-and-polo enthusiast/financier R. Allen Stanford with orchestrating a fraudulent multi-billion dollar scheme that allegedly used false promises and fabricated data to sell what the SEC termed "so-called 'certificates of deposit'" that promised high interest rates. (Stanford has denied the allegations.)

I don't know about you. But when I think about all the incidents over the past year where investment opportunities turned out to be less than what they seemed, I'm inclined to be more than a little suspicious of any institution that claims it can pay four times the going rate for CDs while guaranteeing the security of my principal.

After all, the banking system is pretty simple. Banks pay depositors like you to bring in money that they then invest or lend for a profit. So how is it that one institution can afford to pay so much more than competitors for its investable funds and still make a profit? Are the people who run this bank that much smarter than everyone else? I doubt it.

So what then, could account for this disconnect of dramatically higher yield with no additional risk?

Well, maybe you've misunderstood the ad. Maybe it alludes to FDIC-insured CDs, but the 8% rate refers to some other type of investment that involves more risk.

Or maybe there's some sort of hitch. You get the 8% rate, but only if you also do something else, like promise to tie up your money for a much longer period of time. Annuities that offer high "bonus" rates often come with very high surrender charges that sting you if you withdraw your money early.

Or perhaps this is just some sort of come-on, a way to use the lure of a high rate and FDIC insurance to get you to part with your money.

As I see it, you have two choices. One is to try to figure out whether this offer is on the up and up and, if so, what strings may be attached to it. That may take quite a bit of time and effort, and even then it's possible that you could mistakenly conclude the CD is legitimate when it's not. I'm sure many people looked into Bernie Madoff's background before investing with him and concluded he was a stand-up guy.

The other option is to say that something just doesn't smell right here and move on. You could then open a CD with a bank that you know is actually insured by the FDIC. You can search for banks offering the most competitive CD rates on Bankrate.com. Once you've identified a few, you can ascertain that they are indeed FDIC insured by going to this search tool on the FDIC's site.

There are always going to be seemingly golden opportunities to grab a higher return with low risk. I get questions about them all the time, ranging from tempting payouts on foreign CDs to tantalizingly high yields on Icelandic bonds. But when you step back and think about these offers, you'll usually find that they contain risks you probably haven't thought about.

So to me, at least, the choice you face is a no-brainer. The whole point of putting money into an FDIC-insured CD is because you want the money to be safe. So why even entertain the possibility of placing your 12 grand in jeopardy?

It's possible, I suppose, that in passing on this CD you could just be giving up a higher yield. But if that's the case, so be it. When it comes to the money I really want to be safe, I'd much rather err on the side of being too conservative rather than push the envelope and end up regretting the decision later.

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