Rising interest rates have made certificates ofdeposit attractive again, but some physician-investorsare concerned about being lockedinto a long-term traditional fixed-rate CD shouldinterest rates continue to climb. To counter thisworry, banks are offering flexible, interest-sensitiveCDs that allow physician-investors to take advantageof rising traditional rates. But as with all investmentproducts, you need to investigate these CDscarefully before buying.
Interest Rate Bump
The most common of the new variations of CDs iscalled the bump-up CD. For example, say you buy a24-month bump-up CD with a rate of 2.55%.Interest rates rise, and 10 months into the term of theCD you tell the bank you want to bump the rate up.The new rate would equal the rate the bank is payingon its latest 24-month bump-up CDs. If the rate is2.85%, you would earn that percentage for theremaining 14 months of your CD's term.
Usually you are limited to a one-time bump duringthe CD's term, though some banks allow twobump-ups. You may be limited as to how soon youcan exercise your bump after buying the CD. It maybe within a few days or it may be 6 months. Somebump-ups allow you to invest additional money inthe CD at the time you bump, but this is usually limitedto 20% of the initial investment.
Another twist is the liquid CD. A liquid CD paysa fixed rate its entire term, but it allows you to withdrawwithout penalty a limited portion of the originalinvestment before the CD matures. Should interestrates rise, this provides the flexibility of withdrawingsome money to use or to reinvest at thehigher rates. As with the bump-up CD, you may onlywithdraw once. Some CDs allow all three components:bump-up, additional funds during the bumpup,and a one-time withdrawal. While all this flexibilitycan help you avoid being locked into fixed CDrates, be aware of the trade-offs and cautions.
The interest rates, terms, and restrictions of bumpupsand similar CDs vary widely from bank to bank,so evaluate several before deciding which one is rightfor you. Be sure when you bump up that it doesn'textend the original term. Also compare minimums,as bump-up CDs often have higher minimum investmentsthan a comparable-term fixed-rate CD.
The initial interest rate for a bump-up or liquidCD is usually lower than a comparable standardCD. Around a quarter to half a percentage pointlower is common. Sometimes the difference is smaller,making the bump-up even more attractive. Therisk is that should you guess wrong, and rates don'trise or rise very little during the bump-up CD's term,you may have done better sticking with a comparablefixed-rate CD.
Bump-up CDs tend to be longer-term, thoughthere are exceptions. Many bump-ups are 18months, with 24-month and 30-month common.Some banks only offer 5-year bump-ups. The riskhere is that in a fast rising interest rate environment,even with the opportunity to bump up or make awithdrawal, you won't be able to keep up with risingrates. Usually the advice in a rising interest rate environmentis to stay short term.
While taxable money market mutual funds usuallypay lower interest rates than CDs, you may find ratesclose to short-term CDs. The advantage is that moneymarkets raise their rates often to keep up with overallinterest rate increases so you're not locked in for longperiods. But keep in mind that money market mutualfunds are not federally insured, unlike CDs.
This article has been produced by the Financial Planning Association (www.fpa
net.org), the membership organization for the financial planning community.