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Are step-up CDs a good choice if the Fed raises interest rates?

August 12, 2015

By Richard Barrington | MoneyRates.com Senior Financial Analyst, CFA

Q: With all the talk that the Fed is going to raise interest rates, would this be a good time to invest in one of those step-up CDs that let me switch to a higher rate if rates go higher before the CD matures?

A: An opportunity to make a future choice based on prevailing conditions can be thought of as a financial option. An option is a valuable thing, but as with any thing of value, you should expect to pay a price for it. The question is whether or not the price is worth it.

What's it worth to you?

With a step-up CD, the option to switch to a higher rate in the future often comes at the price of accepting a lower rate initially than you would get on a conventional CD. For example, if the best CD rates for five years were around 2 percent, you might only get a 1 percent rate on a 5-year step-up CD. Therefore, rates would have to rise by 1 percent just for you to draw even with the most competitive conventional CDs, and would have to go even farther for you to make up the ground you lost by starting out at a lower rate initially.

If the gap between the best CD rates and what you could get on a step-up CD were smaller than 1 percent, you would be paying a lower price for the option of raising your rate later on. Knowing that price allows you to better evaluate whether the option is worth it.

Indexed CDs

Indexed CDs are another possibility for a rising rate environment. Rather than giving you a one-time option of stepping up to a higher rate, these adjust automatically to rate conditions based on a specified market index. As with step-up CDs, this feature might come at a price in the form of a discount to conventional CD rates. It also carries the possibility that your rate could go down.

Other rate-changing possibilities

Here are some other deposit account possibilities if you think interest rates are going to rise:

  1. Savings and money market accounts. Rates on both savings accounts and money market accounts adjust periodically to changing rate conditions. The price you pay for this flexibility is that they typically yield a lot less than CDs. However, you can reduce this price by shopping for the best savings and money market rates. The top savings accounts pay about 1 percent these days - better than the average rate on a 5-year CD.
  2. Conventional CD penalties. Rather than exercise a step-up option, you could get a conventional CD and simply pay the penalty for early withdrawal if rates rise. Knowing the size of this penalty would tell you how big a price you would have to pay for this option, though the nice thing about this approach is that you only pay this price if you actually exercise the option.

So, by all means consider step-up CDs as a possible way of preparing for a rising interest rate environment. Just remember to also identify the price you will have to pay in the form of how it compares with competing alternatives. Only by knowing that price can you make a reasonable judgement about whether the option is worth it.

Find out more information about the best savings rates and money market account rates on MoneyRates.

More from MoneyRates.com:

5 ways to avoid early withdrawal penalties on your CD

How to compare CD rates

Ask the expert: When are taxes on CD interest due?

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