Personal CD Investing: Step-Up and Step-Rate CDs

The following is a guest post contributed by Charles Rechlin, a long-time reader and friend of the site. His last guest post covered qualified charitable distributions. I would like to thank Charles for sharing more of his valuable experience on personal CD investing.

Notes on Personal CD Investing: Step-Up and Step-Rate CDs

by Charles Rechlin

Given the stir about the Federal Reserve possibly raising interest rates before year-end, I suppose it’s as good a time as any to revisit the subject of step-up and step-rate CDs.

I confess I have no new or unique insights on this topic. However, I do have a point of view, and would be interested if other readers share it—or perhaps even find things I’ve gotten wrong or am missing.

Definitions

To begin with, there’s often confusion about terminology with these two types of CDs. For clarity, I’ll adhere to the following definitions:

A “step-up CD” (or “bump-up CD”) is a CD that provides the owner the right (usually once, but sometimes more than once) to raise the rate to the rate then posted by the bank or credit union for the same type of CD or a CD of the same maturity.

A “step-rate CD” (or “rising-rate CD”) is a CD that provides for automatic, pre-determined increases in the rate at periodic intervals.

My Approach to Step-Up CDs

The principal question I ask when considering a step-up CD is what value the bump-up right adds to the CD. Almost invariably, my answer is “little, if any.”

For me, that’s because, from a legal and contractual standpoint, the step-up right isn’t much of a “right” at all. The issuing institution, by having the power to set the posted rate from time to time, is given control over whether or not the step-up ever occurs.

A step-up CD is different from a traditional financial option contract, where the marketplace, not the writer of the option, determines whether it is financially advantageous for the holder to exercise his or her rights.

It’s more like a “most favored nation clause,” where you’re promised that if the bank or credit union gives any customer a higher rate than you have on a CD product with the exact same term, you’ll be able to get it as well.

But even viewed in this way, the step-up privilege is pretty anemic. The institution remains in the driver’s seat.

Because I view a bump-up right as being of dubious value, my practice is to pass on step-up CDs unless the initial rate offered is at, above or at least reasonably competitive with the best rate available nationally for a CD of the same maturity with no step-up right.

In the current ultra-depressed interest rate environment, “at least reasonably competitive with” means, for me, within five basis points in the case of a 2- or 3-year CD, or within ten basis points in the case of a 4- or 5-year CD. I won’t invest in a step-up CD of less than two years if there’s a standard CD of the same maturity with a higher rate available to me.

Even when I can find a step-up CD with an acceptable initial rate, however, I seek additional protections.

• I rule out any CD that restricts the time during which the step-up right may be exercised (in other words, the right must be exercisable at all times during the CD’s term).
• I look for a bump-up right tied to the rate posted for a standard-term CD (in other words, I shy away from odd-term bump-up CDs). This is only a strong preference, not a hard and fast restriction.
• I try to limit myself to institutions I view as being sensitive about maintaining a customer-friendly reputation.

This all makes for slim pickings. But, in the past, I’ve found (and invested in) some step-up CDs that I’ve found attractive, or at least acceptable.

For example, some years back I owned what are probably the two most visible step-up CDs offered nationally—Ally Bank’s 2-year Raise Your Rate CD and CIT Bank’s 2-year RampUp Plus CD. I actually managed to raise my rate on them before they matured—a whopping five basis points each!

I presently own a couple of Mountain America’s 5-year One Bump Term Deposits which, when they were issued, had reasonably competitive rates, have step-up rights tied to the credit union’s standard 5-year Term Deposit, and are exercisable at any time during the term.

I’ve done a brief survey of the bump-up CDs currently offered by the banks and credit unions at which I have accounts and have discovered only one in which I have the slightest interest (and it’s an odd-term CD): the 2.00% APY 54-month Rate Climber CD of Elements Financial FCU. I already own several of these CDs, opened within the last year or so.

On the plus side, the 54-month Rate Climber posts a rate I consider reasonably competitive. It also permits the exercise of the step-up right at any time before maturity. In addition, it has an add-on feature I discussed in an earlier post.

The negative is that the step-up right is tethered to this specific type of non-standard CD, so it can be evaded by Elements’ eliminating this non-standard term from its suite of products. Thus, I have to rely on this credit union’s reputational sensitivity, which seems a thin reed for the customer of any institution to cling to.

My Approach to Step-Rate CDs

I don’t see all that many step-rate CDs being offered directly by banks and credit unions. However, they are quite common in the brokered CD market.

I ask two questions when looking at this type of CD. First, what’s the blended yield until maturity—that is, the average yield based on the rate borne by the CD during each of interest periods or intervals? Second, is the CD callable by the institution prior to maturity and, if so, what’s the blended yield on the CD to each of the dates on which it can be called?

Let me illustrate with a brokered CD I purchased in my IRA at Fidelity Investments in March 2015. It’s a 3-year CD of JP Morgan Chase Bank, carrying a 1.25% rate for two years, increased to 2.00% in the third year. It’s callable quarterly at par.

The blended yield currently is 1.25%, and to the maturity date is 1.50%. I invested in this CD because both those yields were competitive with brokered CDs of 2- and 3-year maturities being offered through Fidelity in March 2015. However, if brokered CD rates stay about where they are today, this CD is a good candidate to be called by March 2017.

I’ll only consider step-rate CDs for my IRA portfolio, where I capitalize interest and can afford to defer higher interest payments to later in the CD’s term. In this regard, one of the most interesting CDs I ever owned was the “12345 IRA CD” offered several years back by Androscoggin Bank. This CD bore interest at 1.00% APY in the first year, which increased by one full percentage point each year thereafter until reaching 5.00% APY in the fifth and final year. It wasn’t callable, and I treated it as being identical to a 3.00% APY 5-year CD.

Because I don’t capitalize interest in my non-IRA portfolio, but require a steady, reliable stream of income from which to pay my bills, rising rate CDs are of no interest to me in that portfolio.

And, if truth be told, I often avoid bothering with step-rate CDs—particularly those with multiple rate intervals and call dates—simply because they’re too complicated for my aging brain to process.

Conclusion

The bottom line is that, although I’ve owned a few, I don’t spend much time looking for, or worrying about, either step-up or step-rate CDs.

Perhaps if we had evidence that we could expect a substantial increase in rates by the Fed in the relatively near future, I might spend more time and effort, at least looking for and at step-up CDs.

Right now, however, both of these CD types have pretty much slipped off my radar screen.