Investors who are allergic to risk can always opt for certificates of deposit. They offer a guaranteed rate of return and a fixed interest rate, both of which can sooth the risk averse.
When you invest in a CD, however, you’re agreeing to tie up your savings for months at a time. And when interest rates are expected to keep rising — like they are now — buying a CD may seem silly.
If opening a traditional CD sounds like a bad idea in a rising rate environment, you might consider looking for a financial institution offering a step-up CD.
How step-up CDs work
Banks and credit unions sometimes refer to step-up CDs as bump-up CDs. But in reality, they’re two different products.
Bump-up CDs give account holders the option to raise their annual percentage yield at least once before the end of their term, upon request. For example, the United States Senate Federal Credit Union offers 3-, 4-, and 5-year bump-rate share certificates, each featuring a one-time rate increase.
With step-up CDs, on the other hand, predefined rate increases happen automatically at certain intervals, says Greg McBride, CFA, Bankrate’s chief financial analyst. With a bump-up CD, you might be concerned about timing your rate increase perfectly.
But step-up CDs can be hard to find. Few banks offer them.
One bank that does give its customers the opportunity to open a step-up CD is Luther Burbank Savings, a bank based in Santa Rosa, California.
With the bank’s 18-year step-up CD — which is available nationwide — a 2.63 percent rate applies for the first nine months and a 2.88 percent rate applies for the second half of the term. The blended annual percentage yield is 2.83 percent.
Beware the blended yield
A step-up CD may seem like a dream come true if you’re a risk-averse investor concerned about rising interest rates. But the deals banks offer aren’t always as great as they seem.
When you’re comparing step-up CD rates, pay close attention to the blended annual percentage yield. It’s not simply an average of what you’re earning at each interval. It’s a geometric average, McBride says, not an arithmetic average.
U.S. Bank for instance, offers a 28-month step-up CD. The interest rate tied to the CD increases every seven months, moving from 0.10 percent to 0.30 percent to 0.50 percent to 0.70 percent.
But the blended annual yield, or the effective rate that applies, is actually 0.40 percent APY. And that’s only the yield you receive if you leave all of the money locked up in the CD until maturity.
Often with step-up CDs deals, comparable offers for traditional CDs are much more appealing.
“Just because it is slated to increase at regular intervals throughout the term of the CD doesn’t necessarily mean you’re going to end up better off at the other end,” McBride says. “It depends on the starting point and the magnitude of the increase.”
To invest or not to invest
If the prospect of future interest rate hikes scares you, a step-up CD may not be your best bet. And any financial decision you make — like choosing where to invest your money — should depend on a variety of factors.
“Any investment that you make should have a financial plan and goals that are guiding that decision,” says Taylor Schulte, founder and CEO of Define Financial, a San Diego-based registered investment adviser. “So just because you are a conservative investor or just because you think rates have nowhere to go but up does not provide any merit for buying a step-up CD.”
If CDs are a good fit for your portfolio and you’re concerned about rising rates, consider building a CD ladder. You can buy multiple CDs at the same time across different terms. And when your shorter-term CDs mature, you can replace them with other CD rates that pay a higher yield. Best of all, CD laddering may pay off in the long run.
“You’ll likely see a higher rate of return in your portfolio by building that laddered CD portfolio versus letting the bank do it for you,” Schulte says.