Yields on cash have been pitifully low for years — so small that many investors have chosen the philosophical approach — better to focus on the safety of bank savings, not earnings.
To make more, you can tie your money up longer in a certificate of deposit. But, with interest rates expected to rise, what if newer CDs pay more in a year or two? Wouldn’t you kick yourself for being trapped in an older one that was stingier?
That’s where step-up CDs would seem to come in handy. Also called bump-up, trade-up or similar names, these products allow the investor to move up to a higher yield if prevailing rates change sometime before the CD matures. But the rate will not go down.
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Not all experts are sold on the idea, however, and it has not really taken off. If your bank does not offer a step-up product, shop around the internet, as some of the highest yields are from banks that operate only online.
“They tend not to be useful,” says Ken Tumin, founder of DepositAccounts.com, a service of Charlotte-based LendingTree that provides banking information.
“A common mistake savers make is to think that rates are going up fast,” he adds. “It can make bump-up CDs look more appealing than they are.”
If rates rise slowly, the saver can redeem an older CD and buy a new one that’s more generous.
CDs, of course, are an alternative to savings accounts, money-market accounts and checking accounts. While the others generally allow the investor to withdraw money at any time, cash in a CD is tied up for months or years. The longer the period, the more the CD pays, since the bank knows it can use that money for loans for a given period.
For example, a checking account from online Ally Bank pays just 0.1 percent, an 18-month CD 1.5 percent and a five-year CD 2.25 percent (all for deposits less than $5,000).
Meanwhile, Ally’s Raise Your Rate two- and four-year CDs yield 1.65 percent. The deal allows the depositor to raise the rate once for the two-year and twice for the four-year, going to whatever rate is then paid by Ally’s comparable Raise Your Rate CDs.
The problem is the starting yield is typically not as high as on a CD without the step-up feature.
Ally’s four-year Raise deal at 1.65 percent is considerably lower than the 2.25 percent on its standard 5-year CD, for instance. The step-up deal would be worth it only if you thought rates would rise, and do it soon enough for the new step-up rate to offset what you could have made on the regular CD.
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“If the bank doesn’t keep the bump-up CD competitive as rates rise, you may not get a worthwhile option to bump-up your CD rate,” Tumin says. “Thus, a standard CD with an initial higher rate could offer more interest than a bump-up CD through the life of the CD. You may never get the chance to bump-up the rate high enough and soon enough to offset the lower initial rate.”
Also, the limit of one or two step-ups forces the investor to choose the right moment. The rate could continue rising after your step up, but if you wait and it doesn’t, or it takes a long time to go up further, you’d miss out on the extra interest you could have earned by stepping up earlier.
One alternative is to get ordinary CDs and redeem early to reinvest if rates rise enough to make it pay. Typically, you lose three to six months’ interest earnings for early withdrawal, though banks occasionally offer CDs with no early withdrawal penalty.
“Savers are often better off by choosing a standard CD with a higher rate,” Tumin says. “If savers are concerned about the possibility that interest rates will rise fast, a better alternative is a standard CD with a higher rate and with a small early withdrawal penalty. If interest rates rise fast, the saver can break the standard CD early, take the penalty and reinvest the money into a higher-rate CD.”
Another option is a standard laddering strategy, which means owning a range of CD’s from short to long maturities. The short-term ones will make your money available soon, while the long-term ones will pay more. When the short-term ones mature, you can reinvest in a new CD at the rates prevailing at the time, though there’s no guarantee those rates would be higher.
Savers may also be wise to avoid fixating on yields. With rates as low as they are today, a small increase makes very little difference in actual dollars, and might not be worth fretting over.
After all, even with a low yield the CD serves its primary purpose of keeping your money safe.
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Generally, the Federal Deposit Insurance Corp. protects each depositor for up to $250,000. That’s for each individual, not each account. A couple with separate accounts would be safe up to half a million, which should cover the cash holdings for just about everyone.
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Step-Up CDs Boost Cash Earning Power originally appeared on usnews.com
