What is a Variable-Rate Certificate of Deposit (CD)?
A variable-rate certificate of deposit (CD), sometimes referred to as a ‘flex CD,’ is a type of savings account offered by banks and credit unions. It locks away your money for a specific term while offering an interest rate that fluctuates based on factors like the prime rate, Consumer Price Index (CPI), Treasury bills, or a market index. These CDs are insured by the Federal Deposit Insurance Corp. (FDIC), ensuring your money’s safety up to certain limits.
Key Takeaways
- Flexible Interest Rates: A variable-rate CD has a fixed term but offers a fluctuating interest rate.
- Early Withdrawal Penalties: Typically, there’s a penalty if you withdraw funds before the CD matures.
- In-Depth Research Needed: Finding a competitive variable-rate CD may require thorough research as they are not widely available.
- Profit Potential: These CDs can be highly profitable if interest rates rise and less so if rates decline or remain stagnant.
Understanding a Variable-Rate CD
Variable-rate CDs offer a secure way to earn interest on your savings over a set period. The interest you earn usually remains inaccessible until the CD matures. With limited term options, you might find yourself choosing between 12-, 24-, or 36-month durations.
Finding a suitable variable-rate CD could be more challenging compared to fixed-rate CDs. Smaller community banks and credit unions are often more likely to offer them.
Bump-up or step-up CDs are a subtype of variable-rate CDs. In these CDs, interest rates can only increase, usually limited to once or twice during the term. This might offer additional safety, but often requires manual rate increase requests.
Why Choose a Variable-Rate CD?
Variable-rate CDs provide an adaptable interest environment and are generally considered safe investments because they are FDIC-insured up to $250,000 per depositor. They are attractive options for conservative savers who still want to benefit from potentially rising interest rates.
Additionally, variable-rate CDs are an excellent way to diversify investment portfolios without taking on significant risks. If you’re particularly cautious but want to leave room for potential growth, a variable-rate CD might be perfect for you.
Special Considerations of a Variable-Rate CD
When contemplating a CD with a variable rate, you should be aware that these products often have the greatest profit potential in a low-rate environment predicted to rise. Conversely, high initial rates can drop, decreasing your returns.
Also, consider the early withdrawal penalty clauses and whether they’re stringent. A no-penalty variable-rate CD with lenient withdrawal rules could be more appealing.
Inflation Concerns
Variable-rate CDs are not immune to inflation. During high inflation periods, if the interest rate does not rise in tandem, you might end up with returns that do not keep pace with inflation, effectively eroding the real value of your savings.
Example of a Variable-Rate CD
Imagine Sarah decides to invest in a 12-month variable-rate CD offering interest linked to the Federal Reserve’s federal funds rate minus 0.25%. She starts with $1,000, earning an initial 2.25% when the Federal funds rate is 2.50%. Expecting rate hikes, Sarah chose wisely as the rate increased to 4.75% within six months, meaning she began earning 4.5% - far above her initial rate. Contrast this with her friend Emma, who opted for a traditional fixed-rate 12-month CD at 3%. While Emma’s earnings remained flat, Sarah benefited greatly from the rate hikes.
Are Variable-Rate CDs Insured by the Government?
Yes, variable-rate CDs held in FDIC-member banks are insured up to $250,000 per depositor. This provides an extra layer of security, making these CDs a safe investment option.
What Happens If I Redeem a CD Before It Matures?
Usually, early withdrawal from a CD results in penalties such as forfeiting several months’ worth of earned interest. Some institutions offer penalty-free CDs but expect lower interest rates.
What Determines the Rate on a Variable-Rate CD?
The determining factors for the interest rate applied to a variable-rate CD depend on the financial institution. The rate might be pegged to the federal funds target rate, the bank’s prime rate, or another benchmark like Wall Street Journal Prime Rate (WSJP). These rates can change at the institution’s discretion, often described in the account terms.
The Bottom Line
Variable-rate CDs offer a secure, insured investment option with the potential for higher returns if interest rates rise. Just remember, the earned interest is locked in until maturity, and there are risks of prolonged low interest rates or declining benchmark rates that could erode your potential earnings.
Related Terms: Savings Account, Fixed-Rate CD, Federal Funds Rate, Investment.
References
- Federal Deposit Insurance Corp. “Are My Deposit Accounts Insured by the FDIC?”
- U.S. Securities and Exchange Commission. “High-Yield CDs: Protect Your Money by Checking the Fine Print”.
- Federal Deposit Insurance Corp. “Thinking of Buying a CD? What to Consider Before Handing Over Your Money”.
