Fuzzy interest rate future complicates CD investing

By Sandra Block
USA Today

The Federal Reserve Board hinted recently that given the right planetary alignment, it might raise interest rates.

The Fed isn't expected to raise rates any time soon. Nonetheless, fears that it may be tiptoeing toward an increase unnerved investors, triggering a sell-off in the stock market.

But for investors in certificates of deposit, the Fed's statement offered slender hope of higher returns.

Yet, the specter of higher rates also presents a quandary for CD investors. Interest rates on short-term CDs are barely keeping pace with inflation. You can eke out a higher return by investing in a longer-term CD, but if interest rates rise, you'll be stuck with below-market rates until the CD matures.

Some banks and credit unions are offering an alternative: bump-up CDs. These CDs give you the right to request a rate increase if interest rates rise. For example, if you invest in a two-year CD, and six months from now rates increase, you would be allowed to adjust your CD to the higher rate.

Some bump-up CDs allow you to make one adjustment during the life of the CD; others permit two.

But the flexibility to notch up your interest rate carries a cost.

For example, some banks require you to invest more money or extend the term of the CD to exercise the bump-up option. Others pay a lower interest rate on their bump-up CDs than for standard CDs with the same maturity. For those bump-up CDs to pay off, interest rates would have to rise enough to make up for the lower initial rate. And if interest rates don't rise, you'll be stuck with below-market rates.

Callable CDs are another story. These CDs often offer a higher interest rate than traditional CDs, making them appealing to income-hungry investors. But here's the rub: The bank has the right to cash out your CD after a specific period.

For example, a callable five-year CD would give the bank the right to cash out your CD any time after the first six months. If interest rates go down, the bank will likely call your CD, forcing you to reinvest at lower rates. And if they go up, you'll be stuck with a below-market investment until the CD matures.

Squeezing out returns

You can boost your returns without investing in a nontraditional CD. Some strategies:

• Invest over the Internet. Internet-only banks continue to offer some of the most competitive rates. ING Direct is now paying 2.15 percent on a 1-year CD, vs. the average national rate of 1.66 percent, according to Bankrate.com.
• Check out smaller banks. Some small banks and credit unions offer better rates and lower minimum deposits.
• Ladder your CDs. By investing your money in CDs of different maturities, you can get the higher rates offered by longer-term CDs, but still have the flexibility to take advantage of a rate increase.