What Is a Bump-Up Certificate of Deposit?
A bump-up certificate of deposit is a savings certificate that entitles the bearer to take advantage of rising interest rates with a one time option to "bump up" the interest rate paid. The bump-up certificate of deposit (bump-up CD) yields a lower rate than that of a similar certificate of deposit (CD) with no bump-up option.
Bump-up CDs are also called step-up CDs.
Understanding a Bump-Up CD
A certificate of deposit, or CD, is a time deposit issued by banks to investors who purchase the CDs to earn interest on their investment for a fixed period of time. The savings product pays interest until it matures, at which point, the investor or depositor can access his or her funds. Although it is still possible to withdraw money from a CD prior to the maturity date, this action will often incur an early withdrawal penalty. Usually, the interest rate stays the same for the life of the CD, but there are some options that permit changes to the interest rate. An example of a CD that allows an interest rate change is the bump-up certificate of deposit.
A bump-up CD typically permits a one-time increase in the interest rate affixed to the security. However, CDs with longer terms may have the option to change rates multiple times over the term life of the certificate. Financial institutions may also have a cap on how high the yield can be increased (or bumped up) at any one time. When purchasing a bump-up CD, investors should ensure to find out how many times they are allowed to bump-up the interest rate, and whether they have to extend the term of the CD with each bump-up.
The bump-up CD allows investors to take advantage of rising rates without having to worry about the potential downward adjustments of a variable rate. The purchaser of a bump-up CD expects interest rates to go up. If rates increase, the holder can elect to increase the interest rate to the current higher rate. For example, assume a bank issues a certificate of deposit with a 5-year maturity date and a bump up option. The current interest rate on the CD is 2% and the prevailing yield in the market increases to 2.9% before the CD matures. Investors can exercise their bump up options, increasing their yield to 2.9%. If interest rates don't rise, there is the opportunity cost of having to keep the lower interest rate for the term of the CD. If rates decline after the bump-up option on the CD is exercised, the new higher rate on the CD cannot be changed. In effect, the investor is protected against losing any interest during the decline.
Starting rates on bump-up CDs are lower than the rates on comparable traditional CDs. Hence, investors of CDs with bump up options are at a disadvantage if interest rates decrease or remain unchanged for the life of the time deposit given that they would not get as much yield as the higher paying traditional CDs.