Potential Issues of Step-Up Certificates of Deposit

A step-up CD may seem like a perfect type of CD in today's interest rate environment in which rates are very low, but there's the chance that rates could shoot up due to a surge in inflation caused by government deficits. However, there are some potential issues to consider that may make a step-up CD less useful than you think.

A typical certificate of deposit has a fixed interest rate that lasts until the CD matures. A few banks and credit unions offer a step-up CD that gives customers an option to increase the rate during the term. This is also called a bump-up CD. The bank will allow you to bump-up the rate to the current rate of the same CD. The new and higher rate will then continue until the CD matures.

There are not many banks and credit unions that offer step-up CDs. I just reported yesterday on Connexus Credit Union that offers 2-year and 3-year step-up CDs (see review). One popular bank that has been offering a step-up CD is Ally Bank which calls its step-up CD the Raise Your Rate CD. It has a 2-year term, and the current rate is 1.95% APY as of 6/02/2010.

Here's an example of how you might make use of the step-up option at Ally:

• Open the Raise Your Rate CD on 6/02/10 with a 1.95% APY
• Next year on 6/02/11, Ally's new 2-year CD rate has gone up to 3.95% APY
• You call Ally, and ask for the rate bump
• For the remaining year, the CD earns 3.95%
• The effective annualized 2-year return is the average of 1.95% and 3.95% which is 2.95%

One potential issue with a step-up CD is if the bank doesn't maintain competitive rates. You may never get a chance to bump up your rate even though CD rates at other banks were rising.

Another issue is that you are only given one chance to bump up your rate. Some banks may give you more than one chance, but both Ally and Connexus limit it to just one. When rates start to go up, it'll be hard to know how fast they will rise. How long do you wait before you bump up your rate?

There's going to be the worry that rates will shoot up after you've bumped up the rate. If you wait too long, there won't be much time for the CD to benefit from the higher rate. For example, in the above example, if you waited 18 months into the term rather than 1 year to increase the rate to 3.95%, the 2-year annualized effective yield then becomes 2.45%.

Due to these issues, a CD with a small early withdrawal penalty may be a better choice than a step-up CD. Fortunately, Ally Bank has a very small early withdrawal penalty of only 60 days of interest for all of its terms. I compared Ally's Raise Your Rate CD with its 5-year CD in this review. Some readers have expressed concern that Ally may change the early withdrawal penalty on an existing CD. I have received assurance from Ally's public relations director that the penalty would not be changed on existing CDs.