Bump-Up CDs

A certificate of deposit (CD) is a savings account offered by banks and credit unions. It provides the account holder interest income, in exchange for a commitment to leave his or her money on deposit for a predetermined amount of time, usually, anywhere from one month to five years. Generally, early withdrawal results in a loss-of-interest penalty.

A bump-up is a special type of CD. Whereas a traditional CD offers a fixed rate of interest that does not change, a bump-up CD gives the account holder the option to increase the rate of interest, if prevailing marketplace conditions warrant it. Generally, only one interest rate bump per CD term is permitted, but some longer-maturity instruments allow for multiple bumps.

The process for investing in a bump-up CD begins the same way as the opening of a traditional CD: You must apply online or in person with the issuing bank or credit union. The primary difference is that the terms agreed to on a traditional CD will not change, but you have the option to increase the interest rate offered on a bump-up CD if marketplace conditions warrant it.

During the first year, you earn $400 of interest ($10,000 × 0.040 = $400), but interest rates have risen sharply. In fact, the APY on a new 3-year bump-up CD is 5.50%.

You elect to exercise your bump-up option. As a result, you earn $550 of interest ($10,000 × 0.055 = $550) in each of the remaining two years of your term.

Beyond the interest rate adjustment optionality, there are a few other notable differences between bump-up CDs and traditional CDs. First, bump-up CDs are much less common than traditional CDs. So, the tenures offered for these instruments are relatively limited.

Second, the interest rates offered on bump-up CDs are usually lower than those offered on traditional CDs. The rationale is simple. With a bump-up CD, interest rate risk is shifted from you to the financial institution. The cost for risk reduction is a lower interest rate.

CDs are generally considered safe and stable investments, as they are insured by the Federal Deposit Insurance Corporation (FDIC) for banks and the National Credit Union Administration (NCUA) for credit unions. When properly structured, they are fully insured for up to $250,000 for an individual account and $500,000 for a joint account.

However, traditional CDs have drawbacks such as inflation risk and illiquidity. They require the investor to lock up their money for a specified period and may incur significant penalties for early withdrawals.

Bump-up CDs offer some protection against inflation risk by allowing the investor to adjust the interest rate upward and keep pace with inflation, but they still have the same level of illiquidity as traditional CDs.

Regardless of the terms, CDs are broadly popular with people who value high-quality, stable-value and interest-bearing vehicles and can afford to lock up their cash for a time. Often, these investments serve as a complement to a broader portfolio of cash and long-term holdings, such as stocks, bonds and alternative investments.

When it comes to investing in a bump-up CD or a traditional CD, the most important consideration is your view on the trajectory of future interest rates. A bump-up CD is optimal for an investor that is worried about rising rates. It allows you to take advantage of rising rates, without assuming any downside interest rate risk.

That said, interest rate risk mitigation has a cost. At the onset of opening a bump-up CD, you stand to earn less interest than a traditional CD. Ultimately, if interest rates do not increase, you will earn less income than you could have achieved with a traditional CD.

There are several alternatives to CDs that offer different rates of return and levels of risk.

It is important to note that before investing in any of the above alternatives, consider your financial goals with a trusted financial advisor.