Published in: Banks | Feb. 4, 2019
Is a Bump-Up CD Account Right for You?
By: Dan Caplinger
This banking product gives you a one-time chance to boost your returns. Find out how to take maximum advantage of it.
Opening a certificate of deposit is a great solution for savers who have a fixed amount of money that they can set aside for a length of time. Because of your commitment to your bank to leave your money on deposit throughout the CD period or else face early withdrawal penalties, you'll often get higher interest rates than regular checking or savings accounts provide. At the same time, you'll still get all the benefits of a bank account, including FDIC insurance against a bank failure.
One challenge with CDs is figuring out whether the interest rate will remain competitive not just now but also throughout the term of the CD. That's especially tough when rates are rising, because what seems like a good rate now can look painfully low in the near future if prevailing rates move higher. Yet most CDs don't give you any recourse if that happens, leaving you to wait out the time before maturity until you can reinvest at a higher rate.
Some banks, though, give their investors the chance to boost the rate on their CD if interest rates rise. This type of arrangement, known as a bump-up CD account, can be a great way to protect yourself against rising rates. Below, we'll take a closer look at the basics of bump-up CDs and how to decide if they're right for you.
The best advantage of bump-up CDs
The typical certificate of deposit is easy to understand. Essentially, you're loaning the money you deposit to your bank for a period of time, and in exchange, the bank agrees to pay you interest periodically along with returning your full principal amount when the CD comes due. You have all the flexibility you want on the front end to pick the terms of your CD, with most banks giving you a wide range of maturities that are suitable for both short-term and long-term needs.
The one thing that most CDs don't let you do, however, is to change the rate on the CD in the middle of its term. In a falling-rate environment, that's excellent, because you'll be happy that you locked in a high rate before it disappeared. With a rising-rate environment, you'll wish that you could immediately replace your lower-paying CD with one that has a new, higher rate of interest. Banks don't let you do that with traditional CDs unless you're willing to pay a costly penalty.
Bump-up CDs are different. Initially, bump-up CDs are structured the same way as any other CD, paying you a fixed rate over a set period of time. However, if interest rates on similar CDs rise over time, then the bank gives you a one-time right to "bump up" the fixed interest rate to match up with the new prevailing rate.
For example, say that you buy a bump-up CD with a term of two years that initially pays 2.5%. A year into the CD's term, interest rates have risen to 3%. Under the terms of most bump-up CDs, you'd be allowed to exercise your right to bump up the rate at that point. For the remainder of the term, then, you'd earn 3% interest rather than the original 2.5% rate.
Is it a good idea to use bump-up CDs?
It's very difficult to compare bump-up CDs to regular CDs for a simple reason: You can't predict the future. Most of the time, the rate on bump-up CDs will be less than what a traditional CD with the same term would pay. If rates stay the same or go down between now and when the CD matures, you'd almost always have been better in hindsight going with the traditional CD and its higher initial rate.
Offsetting that risk is the potential reward if interest rates rise. For instance, in the example above, you earned 2.5% for the first year and 3% for the second year, for an average of 2.75% over the two-year term. So if traditional CDs at the time you opened your account paid less than 2.75%, then you would've ended up ahead with the bump-up CD. Conversely, if you could've gotten more than 2.75% on a traditional CD, then you still would've been better off going that route -- even though you ended up using your bump-up option and it did in fact help you boost the interest rate on your CD.
Obviously, you don't know in advance which way rates will go, so you can't just do some math and figure out the right answer. Making a smart decision depends on how much you want the protection that a bump-up CD provides.
Be careful with bump-up CDs
The other big problem with bump-up CDs is that if rates are rising, it's hard to know exactly when the right time to use your one-time bump-up is. For instance, say you have a five-year bump-up CD that initially pays 2.5% and rates rise to 3% after the first year. If you do the bump-up at that point, you'll earn 2.5% for one year and 3% for four years, for an average of 2.9%.
Now say rates keep rising to 3.5% after the second year. If you already used your bump-up, then you're stuck at 3%. If you waited, though, you can now get 3.5% for the remaining three years. Getting 2.5% for two years and 3.5% for the rest boosts your average rate to 3.1%. Again, since you can't predict the future, it's impossible to know for sure the best move.
Finally, bump-up CDs sometimes have tricky provisions. It's important to know which interest rate applies to the bump-up. For instance, if you start with a five-year CD but you exercise your bump-up after a year, be sure to know in advance whether the bump-up rate will be based on new five-year CDs -- or instead on your CD's current maturity, which is now only four years away.
The best bump-up CD for you
If you want a good bump-up CD, look for the following:
- Small differences between rates compared to regular CDs of the same maturity. The less of a hit you take to choose the bump-up, the more likely it is to pay off for you.
- No fees or other unexpected costs.
- Minimum balance requirements that you can afford.
- Bump-up provisions that let you boost the rate to that of a new CD of the original length of time. Because rates on longer-term CDs are generally higher than short-term rates, you'll usually end up ahead this way.
- Extra cash bonuses. Sometimes, banking institutions will run promotions that result in giving you some additional incentives to open a bump-up CD.
Bump-up CDs can be a great way to manage money that you need to keep relatively liquid while still getting top returns. Just be aware of the responsibility to watch prevailing rates -- and to pull the trigger when a bump-up will do you the most good.
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