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Rising-Rate CDs Explained

Banking, CDs
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Investors in certificates of deposit, or CDs, typically give up the flexibility to move funds freely in exchange for higher interest rates than they can get on savings accounts. But with rates for CDs near record lows, it’s hard to rationalize locking up money when the extra yield is so small.

To enhance their CD offerings, banks have introduced some with flexible interest rates that can climb during the life of the account. Often called rising-rate CDs, they can come with complex terms and don’t always provide higher yields, unless you know how to navigate them.

Types of flexible-rate CDs

Step-up CDs: Interest rates automatically adjust at a predetermined time during the term of the account. This can be an attractive option because of its simplicity. Investors don’t have to monitor market rates and can leave it to the bank to make the adjustment when due. This may be the best choice for those who don’t want to keep track of interest rates but would like the possibility of increased yield if they rise during the CD’s lifetime.

Bump-up CDs: Investors get the option to raise the interest rate a certain number of times during the term. For example, a two-year CD might permit one increase, while one with a four-year term might allow two. While they provide more flexibility, it takes careful timing to exercise these options in advantageous ways. They can be a good choice for those who periodically check market rates.

Liquid CDs: These provide the most flexibility, letting investors transfer money out of old CDs and into new ones if rates rise, without facing early withdrawal penalties. This may be the best choice for those who keep a close eye on markets and want the most control over their funds.

What to watch out for

All these CD products come with risks and pitfalls. In order to make the most of a rising-rate CD, investors must pay close attention to interest rates and what their financial institution is offering to pay, but many people don’t have the time for that. Timing can be the key to taking maximum advantage of bump-up and liquid CDs. Those who yield to the temptation and make a move based on the first gain in market rates that comes along may miss out on an even bigger opportunity down the road. In exchange for increased flexibility, the initial yield of a rising-rate CD may trail a standard fixed-rate certificate. Investors also risk the possibility that rates will not rise during the life of the CD, leaving them with a subpar yield.

It’s always good to know the fees and potential penalties associated with any investment, rising-rate CDs included. While these instruments promise investors greater control and flexibility, they can come with complicated conditions that may limit potential yields. Under some circumstances, for instance, investors can find themselves losing part of their principal by moving funds too often.

Rising-rate CDs nonetheless offer investors relatively low-risk ways to gain when interest rates move higher while avoiding early withdrawals. They can also provide a hedge against inflation. Before jumping into one of these products, make sure to check rates offered on standard CDs, particularly those with longer terms. You may find there are better options than a rising-rate CD, with its attendant complications and risks.