How to Invest in CDs as Rates Rise

For conservative investors, deposit accounts such as savings accounts, money market accounts and certificates of deposits are useful for at least a portion of their portfolio.

Unlike other investment products, deposit accounts have the safety of federal deposit insurance. Deposit rates have been exceptionally low since 2009 as the Federal Reserve has attempted to stimulate the economy with near-zero interest rates.

That is finally changing.

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In December, the Fed increased rates, and it suggested additional rate hikes will continue, albeit gradually. It's very likely that we're at the start of a rising interest-rate environment. In such an environment, CDs from banks and credit unions can look unattractive since higher CD rates always appear to be coming soon.

Even though CDs may look unattractive, they can still be the best choice among deposit accounts. The following CD strategies can help ensure that you maximize your interest earnings in a rising interest-rate environment.

CD ladders with modifications for rising rates. If you want to keep things simple, establish a CD ladder. In a CD ladder, you'll have multiple CDs with CDs maturing at regular intervals. In a rising interest-rate environment, CD ladders provide more opportunities to roll over maturing CDs into new higher-rate CDs.

CD ladders are often started with short-term CDs in addition to long-term CDs. When the short-term CDs mature, they are rolled into long-term CDs.

Eventually, all of the CDs in the ladder are long-term CDs.

Since many short-term CDs have rates lower than internet savings account rates, it can make sense to use an internet savings account rather than a short-term CD when initiating the CD ladder. This is especially the case for CDs with terms under one year.

CDs with mild early withdrawal penalties. Whether you decide to have one CD or multiple CDs in a CD ladder, it makes sense to choose CDs with mild early withdrawal penalties.

A mild early withdrawal penalty is no more than six months of interest for a five-year CD. If interest rates rise significantly before the CD matures, the CD investor can come out ahead if the CD is closed early and reinvested in a higher-rate CD. The cost of the early withdrawal penalty can be offset by the additional interest earned on the higher-rate CD.

CDs with mild early withdrawal penalties don't always have the best rates, but a Deposit Accounts study has shown that CD investors often don't sacrifice interest rates when they choose a CD with a mild early withdrawal penalty.

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Early withdrawal penalties only apply to CDs that are purchased directly from banks or credit unions. Brokered CDs that are purchased from brokerages don't have early withdrawal penalties. Instead, the CD investor who wants the funds from a CD has to sell the CD on the secondary market. If interest rates have risen since the time the CD was purchased, the CD will likely sell for a loss, which will likely negate the benefit of using the funds in a new CD that has a higher rate.

Beware of special CDs. Step-up CDs (also called bump-up CDs) may seem like a good deal in a rising interest-rate environment, but they probably won't be as useful as you think. These are CDs that give you one or more options during the term of the CD to increase your rate to the current rate of that same step-up CD product.

One problem with these CDs is that the bank may not keep the step-up CD competitive. If that's the case, you may not get a chance to increase the rate even after rates have risen on many other CDs.

Even if the bank keeps the step-up CD rates competitive, it can be difficult to determine when to exercise the option to bump-up the CD rate. If there's only one option to step-up the rate, there will always be the worry that you're bumping up too soon. If you wait too long, the benefit of the higher rate will be small.

Another special CD that may appear useful when rates are rising is the penalty-free CD. This type of CD may allow for a free early withdrawal of the entire balance, or it may provide a free withdrawal option for only a portion of the balance. For this type of CD to be useful, it should have a rate that's higher than the best internet savings account rate. The savings account rate may not be guaranteed to last like the CD, but in a rising rate environment, this guarantee is not important.

Conservative investors may be tempted in a rising-rate environment to keep all of their safe money in savings accounts and money market accounts. It can be comforting to know that you're not locked into a fixed rate.

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However, moving at least some of that money into CDs, especially those with lower early withdrawal penalties, will likely result in better overall returns. Even if we enter a period where interest rates are rising fast, CDs can result in better returns, especially if the above strategies are used.

Ken Tumin is the founding editor of The Bank Deals Blog at DepositAccounts.com, where he has been covering bank deals and deposit investment strategies since 2005. His insights are gleaned from DepositAccounts' patented rate-tracking technology and its community of fervent savers, along with his own decades of experience in investing in bank-offered savings products.