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When to step-up your (CD) game

By Dr. Don Taylor ·
Friday, December 27, 2013
Posted: 11 am ET

Step-up CDs are designed to let the depositor raise their CD rates to reflect current yields and is one of the many flavors of certificates of deposit that can be incorporated into an overall CD investing strategy.

Some step-up CDs allow depositors to do this just once during the CD's term. Other CDs, typically for longer maturities, may allow more than one step up. Additionally, some step-up CDs allow the depositor to add to the deposited amount when they raise the rate.

If a step-up CD only lets you adjust the rate once then, presupposing a rising yield environment, the depositor has to decide when to elect the rate increase. The earlier the step-up, the longer amount of time the CD will earn the higher rate. However, waiting can mean a even higher interest rate. When should the depositor pull the trigger?

The goal should be to maximize the average yield. With a two-year CD, if the depositor raises the rate in the 18th month, then three-quarters of the CD yield is at the lower yield and only one-fourth of the yield is at the higher yield.

Keep in mind that you're paying a price for the step-up option. A CD with a step-up yield may have a lower yield than a straight, non-step-up CD from the same or another financial institution. The difference is the approximate price of the step-up option. For the depositor to be ahead with the step-up CD, he or she has to capture the yield differential plus a yield pick-up when the step-up option is utilized.

For example, comparing the Ally Bank two-year "Raise your rate" CD with Bankrate's highest national average CD, the Ally Bank CD has an initial rate of 1.1 percent while Bankrate's highest national average CD has a rate of 1.25 percent. Depositors are paying a price for the raise-your-rate option and should strive to be ahead on the rate after two years. To do so, the depositor has to capture on average more than the 0.15 percent initial differential in yields. That's a high bar in today's low interest-rate environment.

Some step-up CDs allow depositors to add additional money to the deposit when they step up the yield. This can be a better deal because the depositor is putting money to work for less than the final maturity at a rate equal to the rates available for the final maturity. Putting one-year money to work at two-year yields is a great deal.

What do you think? Is the step-up option attractive to you as a depositor? What are you willing to sacrifice upfront in yield to have the option to step up the yield later? What's your ideal maturity for a step-up CD?

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