A variable-rate CD is a type of savings account available through banks and credit unions. You may also find them through certain brokers.
All CDs are time deposits, meaning that you put money into a CD for a specific amount of time until it reaches its maturity date. The certificate of deposit pays you interest over this time – called the term of the CD.
Variable-rate CDs are a special type of certificate of deposit that allows the interest rate to fluctuate. This can be beneficial during times of high interest rates – allowing the rate of return to go up. But it can be a problem when interest rates are low – limiting the return on your investment.
How Do Variable Rate CDs Work?
Most CDs have a fixed-rate, which means that the interest rate when you first buy a certificate of deposit is the same for the term of the CD. But if interest rates go up after you buy a fixed-rate CD, you miss out on the higher return those higher interest rates would have provided if you’d waited to buy.
Variable-rate CDs allow the interest rate to fluctuate up and down based on several factors in the financial markets. This allows it to offer higher rates if interest rates rise after you buy a variable-rate CD.
But these same factors allow the rate to go down if interest rates drop.
- Consumer Price Index
- The Consumer Price Index (CPI) is how the federal government measures the average change over time in prices urban consumers pay for a selection of consumer goods and services.
- Market index levels
- A market index is an imaginary or theoretical portfolio of investments used to measure the performance of different financial markets. These are usually based on the performance of a major financial index such as the S&P 500, the Dow Jones Industrial Average or the Nasdaq Composite index.
- Prime rate
- The prime rate is an interest rate determined by what individual banks charge their customers with the highest credit ratings – those least likely to default on a loan. Banks use the prime rate to set interest rates on loans and other financial products.
- Treasury bill yields
- Treasury bill yields are the amount of interest the U.S. Treasury pays to borrow money through selling Treasury bonds. These rates vary depending on the term of the bond – or amount of time the money is loaned to the government by the bond buyer.
Factors That Affect the Interest Rate for a Variable-Rate CD
Variable-rate certificates of deposit – along with other types of CDs – are among the safest types of investments available. If issued through a federally insured bank or credit union, the total amount of all accounts in any one institution – including CDs – are federally insured up to $250,000.
Pros and Cons of Variable Rate CDs
You should weigh the pros and cons of a variable-rate CD before deciding if one is right for you. As with any investment, variable-rate CDs come with both advantages and disadvantages for the investor.
- During times of low interest rates, there is the possibility of having a better return on your investment.
- Variable-rate CDs are most profitable when interest rates are low.
- The interest rate you earn can increase when overall interest rates rise.
- The early withdrawal penalty for a variable-rate CD is typically cheaper than for most other types of CD.
- During times of high interest rates, there is a risk of the variable-rate dropping lower over the term of the CD.
- If interest rates remain low for an extended period, or drop even lower, a variable-rate CD can hurt your investment.
- You often have to pay extra for this “bump-up” feature on a variable-rate CD.
- If inflation ramps up during the term of your variable-rate CD, it can outpace your rate – effectively wiping out any profit from your investment.
Because of the way variable-rate CDs work, they are most profitable when interest rates are low. But if rates remain low, or drop even more, they can hurt your return on investment.
Who Might a Variable Rate CD Work For?
Deciding whether a variable-rate CD is right for you depends on how you want your money to work for you.
CDs provide higher yields than traditional savings accounts and are a low-risk investment – most are federally insured.
CDs are typically favored by people who want flexibility on how long they invest a certain amount of money and those who want to diversify their portfolio with safer investment options.
Variable-rate CDs offer added flexibility to take advantage of rising interest rates, allowing you to cut losses or improve your investment returns in times of rising interest rates.
Understanding the interest rate environment is essential to making a wise investment decision when it comes to a variable-rate CD. A professional financial advisor can help you with that decision.
You should also compare your variable-rate CD choices with other types of CDs to see which one might be the best fit for you.