These special certificates of deposit let you take advantage of rising interest rates to improve your returns. Here's what to watch for.
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If you want to set money aside for a period of time but don't have the time horizon needed to feel comfortable buying stocks, then opening a certificate of deposit at your bank can be a great way to lock in safety and security. With the combination of insurance protection from the Federal Deposit Insurance Corporation and a fixed interest rate, you'll know exactly what your bank is giving you with a CD and how it fits into your overall portfolio.
With most CDs, the rate that you get on day one is the rate that you'll have throughout the term of the certificate of deposit. However, when interest rates are on the rise, it can seem like a bad move to lock in relatively low interest rates on a CD only to see them go up shortly after you open the account. That's especially true if you plan to lock up your money for a relatively long period of time.
In order to address this risk, some banking institutions offer what's known as a step-up CD account. These special CDs give you a way to participate in a rising interest rate environment, giving you the protection you need to feel confident saving your money. Below, we'll look more closely at how step-up CDs work and whether they make sense for you.
What makes step-up CDs different from the crowd
Most certificates of deposit are structured as simple loans from you to your bank. With a typical CD, you deposit your money, agreeing to leave it there for a set length of time. The bank pays interest to you on predetermined dates and then gives you all your money back at maturity. Whether you want to lock up your money for three months or five years, you can typically find a CD that'll work for you.
The problem with most CDs, though, is that once you lock in that rate, you usually can't change it. That's fine if interest rates fall, because you'll have picked the right moment to get what turns out to be a great rate. But if interest rates rise, what you'd like to do is cash in the CD right away and replace it with a higher-yielding CD. Unfortunately, you can't do that without paying a penalty for early withdrawal, which almost always is high enough to take away the incentive to do so.
That's where step-up CDs come in. Rather than having a fixed interest rate that lasts throughout the term of the CD, a step-up CD has a schedule of interest rates that rises over time. For instance, a two-year step-up CD might pay 2.5% in the first year and 3.5% in the second year. That way, if interest rates rise gradually over the course of the first year, you won't feel like you've made a mistake when the second year comes in -- because you know you'll get a healthy increase.
Are step-up CDs smart?
The best way to evaluate step-up CDs is to compare them to the regular CDs that are available at the same time. Then, you can do the math and figure out which one will actually be better for you over the long run.
The key is to determine the actual average yield over the course of the entire CD. With most CDs, that's easy, because the rate never changes, making the average yield equal to the stated CD rate. However, with a step-up CD, there's some math involved. Using the example above, when you take the 2.5% rate for the first year and combine it with the 3.5% rate for the second year, you'll get an average of right around 3%.
What that means is that if the rate on the traditional CD is higher than the average rate for the step-up CD, then you'll be better off going with the traditional CD. But if the average step-up CD rate is higher than the traditional CD, then the step-up's the way to go.
Two things to watch out for
However, there are a couple of potential gotchas with step-up CDs. First, some step-up CDs are callable, meaning that the bank retains the right to pay them off early. That can actually prevent you from ever getting to see the higher rate specified on the rate schedule. Once again using the same example from above, if the two-year step-up CD was callable after one year, then the bank could choose to pay the 2.5% first-year rate and then pay back your principal early. As a result, you'd never get the benefit of the 3.5% rate.
Also, banks can have different policies with respect to early withdrawal on step-up CDs than they have on traditional CDs. If there's any chance that you'll need your money back early, then you'll want to be clear that the penalties are at least no worse on the step-up than they'd be on any other CD.
Step-up CDs tend to be a bit more complicated than regular CDs, and that's why it's important to look closely at the terms and conditions of any step-up CD to make sure that you know what rights you have and the bank has. Otherwise, something can surprise you that will end up eating into your total returns.
How to find the best step-up CD
If you're interested in the benefits that a step-up CD can provide, here's a short list of what to look for:
Top average rates. Don't get tricked into whatever the highest rate in the step-up period is, because that rate will often apply only for a few months at the end of the term. The average rate is the best indicator of whether one step-up CD is better than another.
Minimum investments. Some step-up CDs have higher minimum balance requirements than others. Make sure that the bank you use has limits that you can afford.
No fees. There's no reason to pay things like maintenance fees or other charges for a CD. If your bank wants to impose such fees, find another.
Bonus promotions. Some banks will offer extra promotional bonuses to open a step-up CD account. That shouldn't make up for a subpar rate, but it can help break a tie between two step-up CDs that are otherwise almost identical.
It's important to be smart with your cash, and a step-up CD can give you the best of both worlds in a rising rate environment. Just be sure to understand exactly what the terms of the step-up CD are, and you'll be able to choose the best one to meet your financial needs.The Motley Fool owns and recommends MasterCard and Visa, and recommends American Express. We’re firm believers in the Golden Rule. If we wouldn’t recommend an offer to a close family member, we wouldn’t recommend it on The Ascent either. Our number one goal is helping people find the best offers to improve their finances. That is why editorial opinions are ours alone and have not been previously reviewed, approved, or endorsed by included advertisers. Editorial content from The Ascent is separate from The Motley Fool editorial content and is created by a different analyst team.