Table of Contents
A variable-rate certificate of deposit (CD) is a financial product that locks up your money for a set period of time (or term) and has a fluctuating interest rate. This varying rate of return is what sets it apart from traditional CDs, which pay a fixed rate, meaning you know exactly how much money your money will earn.
When interest rates are high, a variable-rate CD can help pump up your returns, but the opposite holds true, too. Depending on your financial goals, style, and comfort level, a variable-rate CD may or may not be a good option for you.
Key Points
• A variable-rate CD locks in your money for a set term, but unlike traditional CDs, its interest rate can rise or fall over time based on market conditions.
• These CDs can earn higher returns when interest rates increase, but they also carry the risk of lower earnings if rates decline.
• Like most CDs, withdrawing money before the maturity date usually results in a penalty, although some versions offer more flexible (but lower-paying) options.
• Variable-rate CDs are influenced by factors such as the prime rate, market indices, Treasury bill yields, and the consumer price index (CPI).
• These CDs are considered safe investments because they’re insured up to $250,000 per depositor by the Federal Deposit Insurance Commission (FDIC), protecting your funds if the institution fails.
What Is a Variable-Rate Certificate of Deposit?
A variable-rate certificate of deposit, or CD, is a financial product that you can purchase from a banking institution, broker, or credit union. All types of CDs are savings accounts that have fixed investment terms. That means they hold your money for a certain amount of time, be it six months or several years.
You pick a term that suits you best. During that time, your money earns interest, but you’re not supposed to withdraw any funds early, or you’re likely to be assessed a penalty fee. (No-penalty CDs are sometimes available, but usually with lower interest rates.) When the term ends, your CD is said to have matured, and you may withdraw the funds plus interest or roll them over into a new CD. Usually, the total amount of interest is also received at the end of the investment term.
More specifically:
• Traditional CDs pay a consistent rate of interest that you’re informed of at the start of the term.
• With variable-rate CDs, however, the interest rate fluctuates throughout the term.
This means you, the investor, can potentially earn more on your deposit when interest rates go up. Or you could earn less if interest rates go down. Several market factors influence interest rates. These include the prime rate, treasury bills, market indices, and the CPI.
One last note: CDs are insured. They’re time deposits protected by the Federal Deposit Insurance Corporation. If the bank holding the CD were to fail, you’d be insured up to $250,000 per depositor, per account ownership category (such as single, joint, or a trust account), per insured institution.
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Special Considerations of a Variable-Rate CD
Here are a few key things to consider when looking into investing in variable-rate CDs. This type of CD is generally most profitable if purchased when interest rates are low because it’s more likely that the interest rate will increase during the investment term. For this reason, there’s a higher demand for these CDs when interest rates are low.
There are four main factors that influence interest rates. These are:
• CPI: The federal government uses the CPI to calculate changes in the amount that consumers pay for certain products and services. Whatever the current CPI is can affect how interest rates fluctuate.
• Market Index Levels: Another factor that affects interest rates is the performance of investment portfolios, such as major market indices. Some indices that are often analyzed include the S&P 500, the Dow Jones Industrial Average, and the Nasdaq Composite Index.
• Prime Rate: The prime rate is the interest rate that banks charge customers who have the highest credit ratings. These customers are the least likely to default on loans, so they get the best interest rates.
• Treasury Bill Yields: The U.S. Treasury sells Treasury bonds in order to raise money, and it also pays interest on those bonds. The interest rate associated with Treasury bonds depends on the amount and time period of the bond.
It’s worth noting that, during times of high inflation, CDs may not be your best option. If inflation surges, even a variable-rate CD may not be able to keep pace. At the end of your term, you may find that your investment has lost ground versus inflation.
Another factor to consider before you lock in on a variable-rate CD is the fee for early withdrawals. Some variable-rate CDs have higher fees than others. If there’s a good chance you may end up withdrawing funds early, before a CD’s maturity date, you should check those penalties and make sure they aren’t too steep.
Pros of a Variable-Rate CD
All CDs are known to be very safe investments since they are federally insured up to $250,000, as noted above. In addition to that security, there are several benefits to investing in variable-rate CDs.
High Yield on Investments
Variable-rate CDs are secure, insured accounts that can provide a higher rate of return than other types of savings accounts. For instance, when you buy a fixed-rate CD, you might miss out on the opportunity to earn a higher interest rate if the market ticks upward. Variable-rate CDs, however, can respond to market conditions. If you buy a variable-rate CD when interest rates are low, you can potentially earn more as rates increase.
Profitable When Interest Rates Are Low
When interest rates are low, demand for variable-rate CDs increases, as does the profit potential. That’s because it’s more likely that interest rates will increase after you purchase one. The interest rate can tick upward and earn you more on your money.
Lower Withdrawal Fee
Generally, variable-rate CDs come with lower penalties on early withdrawals than other types of CDs.
Recommended: How Can I Buy a Bond?
Cons of a Variable-Rate CD
While there are several reasons variable-rate CDs make good investments, they do come with a few downsides to consider before you invest.
Low Interest Rates
Although a variable-rate CD provides the opportunity to snag higher interest rates, it also creates a significant risk of earning a lower rate if market rates go down. If you buy a variable-rate CD when interest rates are low with the hopes that they’ll increase, there’s no guarantee that this will happen. This means it’ll continue to earn a low interest rate for some or all of the duration of the CD term. In this case, you may have lost out on the possibility of earning a higher return elsewhere.
Paying Extra for “Bump-Up” Feature
Although interest rates can increase or decrease with most variable-rate CDs, there are some that have a “bump-up” feature. This allows for a one-time rate boost (or possibly a few rate hikes) during the CD’s term, but you may well have to pay extra for this “bump-up.” This is because the initial interest rate is typically lower than it would be on a fixed-rate CD.
Inflation Can Outpace Your Rate and Wipe Away Profit
There’s a chance that inflation will increase during the term of a variable-rate CD, as noted above. If this happens, inflation could end up being higher than the interest rate you’re earning. That could effectively cancel out your earnings.
Variable-Rate CD: Real World Example
All this talk of varying interest rates can be hard to get a handle on without a concrete example. So consider the following:
• A CD has a three-year term and a guaranteed repayment of the principal deposit.
• The starting rate is 4.00%.
• During the term of the investment, the rate drops from 4.00% to 2.00%.
• To determine the amount of interest you’d receive, you’d take the difference between the initial rate and the final rate, which is 2.00%.
• So at the end of the term, you’d receive your initial deposit plus 2.00% interest. That’s half what it was when you started.
Obviously, you, the CD account owner, would be happier if the reverse were true, which it could be!
What Happens if I Redeem a CD Before It Matures?
Most CDs have fees for early withdrawal. These typically involve losing interest that’s been earned and occasionally a bit of the principal. (Generally speaking, you don’t receive earned interest until a CD matures.)
However, some variable-rate CDs do offer early withdrawals with no penalties for fees. These CDs usually have a lower interest rate, so you’re paying for this flexibility.
Recommended: How Can I Invest in CDs?
The Takeaway
CDs provide a safe place for your money to grow for a specific period of time. Most of them have fixed interest rates, but variable-rate ones are also often available. These can come with some risks. Time things right, and you could earn a healthy return on your investment. But if rates don’t head in a positive direction, you may not even be able to keep up with inflation.
CDs aren’t the only game in town for earning interest. Also consider the kind of interest you can earn from checking and savings accounts.
Interested in opening an online bank account? When you sign up for a SoFi Checking and Savings account with eligible direct deposit, you’ll get a competitive annual percentage yield (APY), pay zero account fees, and enjoy an array of rewards, such as access to the Allpoint Network of 55,000+ fee-free ATMs globally. Qualifying accounts can even access their paycheck up to two days early.
FAQ
Are variable-rate CDs issued by the government?
Variable-rate certificates of deposit aren’t issued by the government, but the Federal Deposit Insurance Commission, an independent agency of the federal government, insures them up to $250,000 per depositor, per account ownership category, per insured institution.
What determines the rate on a variable-rate CD?
Several factors can affect the interest rate of variable-rate certificates of deposit. These include the prime rate, market indices, treasury bills, and the consumer price index.
Do CDs have fixed interest rates?
Many certificates of deposit (CDs) have fixed interest rates, but variable-rate CDs have interest rates that fluctuate throughout their term. It’s up to you which type you invest in.
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