When to exercise a "step-up" option on a step-up CD?

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nisiprius
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When to exercise a "step-up" option on a step-up CD?

Post by nisiprius » Sun Feb 10, 2019 3:50 pm

I'm confronted with this, not because I have a step-up CD yet, but because I've decided to buy a CD--based solely on its fixed rate and term, plus an extremely strong preference not to increase the number of banks I have accounts at (i.e. it's at at a bank I already have accounts at). And the CD has a step-up feature, whether I want it or not. So I want to be thinking ahead.

The CD has a 22-month term, and the APY is 0.6% higher than their 2-year term CD.
The Step-Up option may be used only once during the 22-Month term. When you request to Step-Up your 22-Month CD, the new rate will be equal to the then-current 24-Month CD rate. The new adjusted rate will be in effect from the date of request to the renewal date.
Of course I do not know what is going to happen to the interest rates for 2-year CDs. For the sake of strategizing I am willing to assume that it rises linearly.

I've done some spreadsheet work, and the conclusion I come to is that, assuming that linear rise, if the 2-year rate passes the baseline for the step-up CD in month X, the best time to exercise the step-up is about midway between X and 22 months.

I also come to the conclusion that on a $10,000 CD, if the 2-year term never rises above the step-up CD's initial rate, then the CD will earn, ballpark, $475 total in interest over the full 22 months. If the 2-year rate rises to a full percentage point higher than the step-up's initial rate, the effect of exercising the step-up at the best time is to raise the total interest paid, over the full term of the CD, by less than $30. Even if it rises to two percent above the step-up's initial rate, exercising the step-up only adds $70. If it only rises to 1/2% higher, exercising the step-up only means an extra $10. In other words, it is not hugely important.

Has anyone else analyzed this or know of an analysis?
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.

BluesH
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Re: When to exercise a "step-up" option on a step-up CD?

Post by BluesH » Sun Feb 10, 2019 4:51 pm

Thanks Nisiprius. No, I know of no other analysis, but I trust that yours is accurate. Your post caught my attention because I just did a step-up on my Ally "Raise Your Rate" CD. It's a 2 year CD purchased in May 2018 for 100K. I just took advantage of a 0.2% bump, because I figured rates aren't going back up in the next few months, and 15 months at a bit higher rate is likely to be better than a couple tenths higher than that, but near the end of the term. By collecting 0.2% extra for 15 months, I should gain an extra $250.

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segfault
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Re: When to exercise a "step-up" option on a step-up CD?

Post by segfault » Sun Feb 10, 2019 4:58 pm

Cue the "market timing" posts!

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Re: When to exercise a "step-up" option on a step-up CD?

Post by nisiprius » Sun Feb 10, 2019 6:07 pm

segfault wrote:
Sun Feb 10, 2019 4:58 pm
Cue the "market timing" posts!
Oh, sure. But I'd rather act on an assumption of a linear rise than never take the step-up at all while waiting for the highest rate.
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.

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HueyLD
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Re: When to exercise a "step-up" option on a step-up CD?

Post by HueyLD » Sun Feb 10, 2019 7:10 pm

What is the EWP on the raise your rate CD? And what is the EWP on the regular fixed rate CD such as the 2 year CD?

I think you need to incorporate the EWP in order to see the opportunity cost.

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