The main attraction of a certificate of deposit (CD) is its fixed interest rate. Opening a CD in a bank or credit union allows you to lock in an interest rate that remains the same throughout the CD's complete term, which can be months or years.
Standard CDs focus on locking in that interest rate for the term of the CD. However, bump-up and step-up CDs are a new option in which the interest rate increases over time, following the changes in the market.
What are Bump-Up and Step-Up CDs?
Bump-up and step-up CDs allow for increases in the interest rate during the CD's term. Bump-up CDs allow you to choose when you get a boost, while the bank or credit union chooses the increase in advance for a step-up CD.
Bump-up CDs
Unlike a traditional CD's fixed interest rate, a bump-up CD will allow a one-time increase in the interest rate, which will lock in until the maturity period ends. A CD with a more extended maturity period, like four years, may allow a second increase in its interest rate.
Bump-up CDs require the deposit holder to request the rate adjustment. For instance, a bank or credit union can offer a CD with a 24-month term and one bump-up option. For example, if the current interest rate is 2 percent and will increase to 2.9 percent in seven months. The seventh month will allow you to bump your interest rate to 2.9 percent to get increased returns for the remaining 17 months.
Whenever the rates decline again, you'll be able to enjoy the higher interest rate throughout the remainder of the maturity period.
Step-up CDs
Step-up CDs have interest rates that increase in phases over the maturity period. For example, your certificate of deposit can have an interest rate of 0.5 percent and have a schedule to increase it by 0.1 percent every six months for four years. That way, you'll have a CD with a 1.1 percent by the end of its maturity period.
Advantages and Disadvantages of Bump-Up CDs
Advantages of Bump-up CDs:
- Taking advantage of rising rates: Bump-up CDs are a great option when you expect rates to rise. You can purchase a bump-up CD and choose an increase at a later date whenever the interest rates rise to get a better return.
- Flexibility in rates: An increase in interest rate is allowed only once or twice during the CD's maturity period. The rate adjustment request must come from the deposit holder.
- Secure investment: Bump-up CDs purchased through federally-insured banks and credit unions are protected by up to $250,000 by the FDIC and NCUA, respectfully.
- Guaranteed rates: The rates on bump-up CDs are more competitive than step-up CDs.
- Availability: Although less common than traditional CDs, banks offer bump-up CDs more often when compared to step-up CDs.
Disadvantages of Bump-up CDs:
- Intervention required: Customers must choose the best time to request the rate adjustment to maximize their CD's growth.
- Lower starting rates: Bump-up CDs typically have a lower interest rate than traditional or variable-rate CDs.
- Limited terms: Bump-up CDs are usually available with limited-term options.
- Lower rates: Bump-up CDs offer less competitive rates compared to traditional CDs.
Advantages and Disadvantages of Step-Up CDs
Advantages of Step-up CDs:
- Secured investment: Step-up CDs, when purchased through credit unions and banks that are federally insured, are secured up to $250,000.
- Guaranteed rates: Step-up CDs typically offer better fixed-rate growth when compared to other money market accounts with variable rates.
- Flexibility in rates: With a step-up CD, the rate increase is on a predetermined schedule. The schedule helps you compare the CD returns with those offered in a traditional CD so you can choose the CD with the most growth potential.
Disadvantages of Step-up CDs:
- Limited terms: Step-up CDs usually have limited-term options.
- Scarcity: Banks and credit unions typically do not offer step-up CDs.
- Low rates: Step-up CDs usually do not have a competitive rate compared to blended or other types of CDs.
Takeaway
In a growing market, a traditional CD with a fixed interest will make you lose out on any potential increase in interest rates. In contrast, getting a bump-up or step-up CD will allow you to increase your interest rate and get better returns after the CD's maturity period.