You'll find a variety of CD options that let you take advantage of rising interest rates. But they're not all as good as they seem.
Have you noticed your local bank trotting out some exciting-sounding CDs recently? According to the sales pitches, they're designed to give investors the security of CDs plus the upside reward of rising interest rates. But, in truth, they aren't new (they've been around since the '80s in various mutations), and they aren't necessarily what they're cracked up to be. Here's a rundown of the common options, and what you need to be aware of.
Step-up CDs feature interest rate increases at one or several predetermined intervals. For instance, Wachovia offers a 24-month "step-rate" CD, with guaranteed interest hikes every six months. It starts out at a 4 percent rate, and ends up at 4.78 percent after 18 months.
Bump-up CDs allow you to tell the bank when you want to take advantage of rising rates, usually just once during the term of the CD. A typical example: You can buy a 20-month bump-up from VA-based United Bank that was recently getting 4.25 percent. You can call United in, say, three months to get its new hypothetical rate of 4.50 percent, which will apply for the remainder of your term.
Liquid CDs allow you to withdraw cash without penalty if you meet certain requirements. The idea: If interest rates rise, you can take money out to reinvest at a higher rate. For example, Washington Mutual requires you to keep at least $5,000 in its 10-month liquid CD, but you can withdraw cash above that amount once a week.
Compared to those for fixed-rate CDs, minimum investments are often higher, terms can be longer, and hefty early withdrawal penalties apply (like forfeiting three to six months' worth of interest). Beware that some variable-rate CDs adjust lower if interest rates drop.
"But the biggest downfall of these CDs is that you typically settle for a lower return initially in order to capitalize on a higher return later," warns senior financial analyst Greg McBride of Bankrate.com, a personal finance website. "That difference may be a quarter or even a half percentage point." Depending on the pace of interest rate increases, it may not be possible to make up for your lower initial rate.
One-time bump-ups can give you more control, but you have to accept more responsibility. "You basically have a single bullet in the gun, so you have to be really judicious in pulling that trigger," adds McBride. Fire too soon, and you miss out if rates keep going up. Fire too late, and you miss out on earlier increases.
The details differ from bank to bank, so shop around. Start out at http://www.bankrate.com to compare national and local CD rates. Or think about putting cash into money-market mutual funds or deposit accounts. They raise their rates more often, and have yields that can be competitive with short-term CDs, especially at online banks.
One last insider tip comes from Steve Austin, executive vice president of BankSouth in Tulsa, OK. When comparing interest rates, try asking your local bank for a rate higher than its advertised one. The quarter of a percentage point you might add to that traditional CD may end up making it a better deal than the bump-up CD you were considering.