As the Federal Open Market Committee (FOMC) continues to lower the Fed Funds rates – keeping the rates hovering between 0.00 percent and 0.25 percent – the interest rates on certificates of deposit continue to decline too. Some investors remember a time when a 1-year certificate of deposit could earn them anywhere from 2.25 percent to 2.40 percent. They may also remember when returns dropped to 2 percent and then again to 1.5 percent. Some financial experts say there is a solution to the challenge with certificates of deposit, which include certificates of deposit with bump-up and step-up options and investing in longer-term certificates of deposit with low early withdrawal penalty fees.
The Strategy
The strategy is relatively simple. Invest in certificates of deposit with features that allow you to hedge against further drops in the interest rate. Certificates of deposit with a step-up option should be your first stop. A step-up option on certificates of deposit will increase your interest rate when interest rates in general increase. You can buy these types of certificates of deposit through brokerage firms. The major drawback is that these are long-term investments, with the shortest interval being a12 years, so your money is tied for the long haul.
While step-up certificates of deposit provide an automatic increase in the interest rate, bump-up certificates of deposit allow you to choose a higher interest rate if interest rates increase. If you own a 3-year certificate of deposit with a bump-up option that pays interest of 2.1 percent and six months later the bank is offering the same certificates of deposit to new buyers at a rate of 2.5 percent, you have the option to bump-up your certificates of deposit to the higher interest rate. The major drawback to these types of certificates of deposit is that there tends to be limitations on when and how often you can bump-up the interest rate.
Since long-term certificates of deposit tend to pay higher interest rates than short-term ones, you can also use the strategy of investing your money in certificates of deposit with longer terms. The key to this strategy is to find long-term certificates of deposit with low penalty fees. The low penalty fees allow you to withdraw your money early if interest rates increase – without jeopardizing your principal balance – and reinvest your money in the higher-paying certificates of deposit. For example, a 5-year certificate of deposit paying 3.5 percent with a 6-month penalty fee for early withdrawal still allows you to earn 1.77 percent for withdrawal at one year, 2.63 percent in year two, 2.92 percent at year three, and 3.06 percent at year four.
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