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Step-up CDs: What they are and how they work

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Investors who are averse to risk may want to explore certificates of deposit (CDs), which offer a guaranteed rate of return and a fixed interest rate — both of which can soothe investor jitters.

When you invest in a CD, you agree to tie up your savings for months or years at a time. That’s potentially an issue when interest rates are rising. But when they’re falling, a CD let’s you lock in an interest rate, ensuring your savings will earn a set rate of return.

With a step-up CD, you’re not only locking in a rate, but you’re also putting yourself in the position to earn a higher rate of return later on. Here’s what you need to know about step-up CDs.

What is a step-up CD?

A step-up CD is a deposit account that allows savers to lock in an interest rate for a set number of months. Before the CD matures, the interest rate associated with the account increases to predetermined levels on scheduled dates.

One downside: Early withdrawal penalties still apply with step-up CDs, which means you’ll pay a price for pulling the money out of your account before it matures.

Another problem is that step-up CDs aren’t easy to find. Few banks these days offer them.

[COMPARE: Best 1-year CD rates]

How step-up CDs work

Step-up CDs are sometimes referred to 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 (APY) 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 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.

Beware the blended yield

A step-up CD may seem like a dream come true if you want a rate increase in a declining rate environment. But the deals banks offer aren’t always as great as they seem.

When you’re comparing step-up CD rates, be sure to note the blended APY. 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 0.05 percent to 0.25 percent to 0.45 percent to 0.65 percent.

But the blended annual yield, or the effective rate that applies, is actually 0.35 percent APY. And that’s the yield you receive if you leave all of the money locked up in the CD until maturity.

Often with step-up CD 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.”

[READ: How much money should you keep in a CD]

To invest or not to invest

A step-up CD may seem like your best bet if you want a fixed rate of return that you’re certain will increase over time. But choosing where to invest your money should be based on several 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 advisor.

If CDs are a good fit for your portfolio and you’re concerned about declining rates, consider building a CD ladder, where you buy multiple CDs at the same time with different terms. When the shorter-term CDs mature, renew them or replace them with new ones. At the same time, you’ll have longer-term CDs in the mix that will likely pay a higher yield than the shorter-term ones.

“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.

Alternatives to step-up CDs

Consider shorter-term CDs instead if you don’t want to lock up your money for the duration of a given step-up CD. Having access to your funds relatively soon can be beneficial if rates rise or if you decide to start investing the money elsewhere.

You may also choose a bump-up CD that lets you request one or more rate increases during the term in the event the rate offered by the bank improves.
Like step-up CDs, bump-up CDs typically carry an early withdrawal penalty.

Other alternatives to step-up CDs include short-term bond funds, which often carry similar terms to CDs and can provide strong yields. Money market accounts can also earn a competitive rate of return, and they conveniently allow you to withdraw money without penalty.

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Written by
Karen Bennett
Consumer banking reporter
Karen Bennett is a consumer banking reporter at Bankrate. She uses her finance writing background to help readers learn more about savings and checking accounts, CDs, and other financial matters.
Edited by
Wealth editor