Reaching for Higher Interest Rates
Earn better yields today without locking yourself out of even higher ones next year
By Stephanie D. Smith

(MONEY Magazine) – Did you notice earlier this year when your local bank branch stopped posting the interest rates it paid? No wonder: The average bank money-market account was yielding a microscopic 0.45% in June, a record low. The average one-year certificate of deposit bottomed out last year at a barely there 1.04%. No window display in the world could make those rates enticing.

Things are better now—and are likely to get better still in months to come. The average rate on taxable money-market accounts is inching up, and some lenders are already offering 2% or more. One-year CDs recently averaged 1.71% and should top 3% by mid-2005, according to Next year, for the first time in a long time, it will pay to shop for yield.

Granted, you won't get rich at 3% a year. But you'll always need to keep a portion of your money in short-term savings, and as long as you stick to ultrasafe CDs and money-market vehicles, there's virtually no risk in trying to make the most of today's rising yields. Just keep these rules in mind.

Keep it short. When rates are headed north, stay flexible—that is, find the highest returns you can for the shortest term. That way, you'll be able to quickly reinvest your cash at higher yields if and when rates take off again.

Over the next few months then, you may be better off keeping most of your cash reserves in a money-market account or fund, from which you can withdraw cash at any time without penalty, instead of tying up your savings in CDs—even though certificates are yielding anywhere from a quarter of a percentage point to 2½ points more. Or you might split that cash between a money-market vehicle and shorter-term CDs—for instance, choosing a six-month CD (recent average: 1.35%) over a one-year CD (1.71%), which in turn would be a better choice than a five-year certificate (3.51%), despite the nominally higher rates on the longer maturities. The trade-off in giving up a little yield now for the possibility of a lot more yield later is worth it, says Greg McBride, an analyst with

If you're in the 28% tax bracket or higher, you may also want to take a look at tax-free money-market mutual funds. Although their nominal rates are lower than taxable money funds (1.14%), you don't pay any federal income tax on the interest you earn; depending on the securities in the fund and the state you live in, you may not pay state income tax either. The result is a higher net yield. At a recent average rate of 1%, tax-free money funds offer the equivalent of a 1.39% taxable return if you are in the 28% bracket and 1.49% for those in the 33% bracket. Peter Crane, vice president of iMoneyNet, a money fund research firm, points out that the gap between taxable and tax-free rates bounces around quite a bit. Still, historically, if you're in the 28% bracket or higher, the tax-free yield has tended to net you more money most of the time.

Consider new options, but cautiously. To capitalize on consumers' renewed interest in savings products, banks are busily touting enticing twists on traditional CD offerings—the rising-rate era equivalent of yesterday's giveaway toasters and coffee mugs. Before you leap at the deals, though, you need to read the fine print. While virtually all of the new variations give CD owners an opportunity to participate in possible future rate increases, they come with trade-offs. Among the most common: higher minimum investment requirements, lower initial rates, and limits on how much you can benefit from future rate hikes. Says Crane: "I'm always critical of new savings products because you have to pay a high price for the option."

Of the CD variations currently being promoted by lenders, your best bet is probably the bump-up CD, which allows you to adjust your rate higher once during the term, to the best deal then offered by the bank on certificates of comparable maturity. Offered by such institutions as Washington Mutual (800-788-7000) and Bank of America (800-900-9000), these CDs allow you to choose when your rate adjusts. Conversely, with variable-rate and index-linked CDs, your return would automatically drop if rates slid, introducing an element of risk to what is supposed to be a safe investment. (For a more in-depth look at the pros and cons of these special CD offers, see the table below.)

Build a ladder. Another way to add flexibility to your cash investments is to use a strategy called laddering. Here's how it works: You divide the money you have to invest among CDs of different maturities—if you have, say, $10,000 to invest, you might put $2,500 in a six-month CD, and another $2,500 each in a one-year, two-year and three-year certificate. Then when the shortest-term CD matures, you reinvest the money in a higher-yielding CD with a longer term. The net effect is that some of your cash earns higher yields immediately, and you're poised to capitalize on additional rate increases when the next CD in your ladder matures.

Shop around. Whether you opt for traditional savings instruments or new twists on old favorites, look farther afield than your local bank for the best deals. Typically you'll find the most competitive rates at online or smaller regional banks and credit unions. For instance, online bank ING Direct (877-469-0232) was recently paying 2.2% on its money-market accounts, with no minimums or fees. Meanwhile, you can earn 2.53% on six-month CDs from Imperial Capital Bank in California ($2,000 minimum; 800-455-4485) and 3% on one-year certificates from Western Financial in California ($100 minimum; 877-932-1234). For a list of the top current yields around the country on a variety of savings vehicles, see "The Numbers" (page 191) or check online at

Sure, it takes a little more homework to find the best deals (usually a few phone calls to ensure that the rates listed are still available) and a little more legwork to set up the account (a phone call or online application is often all that's required). But that's a small price to pay to safely earn an extra one, two or more percentage points on your money now, and the flexibility to land even better rates next year.


New Spins on Old CDs

To attract customers, many banks are offering new features on CDs that allow savers to take advantage of rising rates. Before you hand over your money, though, be sure you understand the inevitable trade-offs that come with such flexibility.