A prime example of savings with CDs

Q: I have a small CD. Its interest rate is determined by the daily prime rate. Is this type of CD a good investment compared with other conservative investments? What exactly is the prime rate, who or what organization calculates this figure, and where can I find this figure published on a daily basis?
- M.F., Kennebunk, Maine

A: Since your CD's interest rate is tied to the prime rate, which fluctuates, so will your return. It's that simple, says Laura Bruce, a senior reporter with Bankrate.com, a financial services website.

In exchange for a little extra interest than you might get with a fixed-rate CD with a similar term, you take on some risk that the rate will drop. But these are good CDs to own in a rising rate environment such as we're experiencing today.

Prime historically has been the interest rate that lenders charge their best customers. A widely used benchmark, it's determined largely by the discount rate set by the Federal Reserve.

Lenders wanted to be able to tell their really good customers that they were special, says Ms. Bruce, so they artificially jacked up the prime rate and started giving their best customers rates "below prime," just the way some stores raise prices and then offer you a discount to make you feel good. The Wall Street Journal publishes a prime rate based on what the 30 largest US banks are charging.

The current prime rate is 7.75 percent, so your CD may have an interest rate around 4.75 percent. But different banks have different formulas when it comes to prime rate CDs. Your bank should be able to give you the formula it uses.

Q: My husband is retired and I'm a self-employed musician. We receive Social Security and paid off our mortgage in 1996. We live in a very expensive housing area. To raise money, I'm researching whether to obtain a reverse mortgage or a home equity loan. Our children think that we should go for the reverse mortgage. But the start-up expenses are very high, along with interest. The equity line would mean paying something back monthly. I'd really like to get this resolved because the start-up costs and interest rates have already risen since last year. We really need a better car along with some house repairs.
J.S., San Mateo, Calif.

A: It's a tough call on which works best, says Vince Clanton, a certified financial planner in Atlanta. But in this era of rising interest rates, you could find yourself in a very uncomfortable position if your home equity loan is tied to the prime rate, he warns.

Mr. Clanton suggests a third alternative, which would be to sell your home. This step would allow you to move to a less expensive dwelling and invest the difference to provide an income stream. By doing so, you could conceivably improve your lifestyle, preserve future options, and remain out of debt.

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