What Is a Variable-Rate Certificate Of Deposit?

Variable-rate certificate of deposit is a certificate of deposit (CD) with a fixed term but a fluctuating interest rate. Several factors determine the rate, such as the prime rate, consumer price index, treasury bills, or a market index. The basis for the amount paid out is on a percentage difference between the beginning index and the final index. The Federal Deposit Insurance Corporation (FDIC) protects variable-rate CDs and other CDs.

Key Takeaways

  • A variable-rate certificate of deposit is a financial instrument with a fixed term and a fluctuating interest rate that is based on an assortment of factors, from prime rate to consumer price indexes to market indexes.
  • Typically there is a penalty associated with early withdrawal of funds in a certificate of deposit.
  • Variable-rate CDs are most profitable during times of low interest rates, though prolonged low rates can adversely affect returns.

Understanding a Variable-Rate Certificate Of Deposit

A variable-rate certificate of deposit allows investors to put their money into a secure, protected account where it will earn a relatively modest amount of interest over the life of its term. The earned interest is usually inaccessible to the account holder until the certificate of deposit (CD) matures. Some issuers do offer a penalty-free CD which allows for the early withdrawal of funds. However, the interest rate will likely be lower than CDs that do not provide this option. 

A variable-rate CD pays an interest rate which can go up and down throughout the life of the security. The exact factors that will determine the interest rate of a variable-rate CD will vary depending on the institution. In contrast, a fixed-rate CD has a "locked in" interest rate with a basis from CD origination. The rate will remain the same throughout the entire term.

A certificate of deposit is generally considered to be one of the safer ways to invest your money, especially since the FDIC protection backs most of them. CDs overall are among the most reliable, low-risk investment options available. They appeal to conservative, risk-averse savers and investors. Investing in CDs is also an excellent way to diversify the risk of your portfolio. For new or cautious investors, a fixed rate CD may be the preferable place to start, but those who are comfortable increasing the risk just a little bit may want to consider a variable-rate CD.

Things to Consider with a Variable-Rate CD

When considering a CD with a variable interest rate, there are a few things you will want to keep in mind. First, remember that these CDs generally have the most significant profit potential during times of low-interest rates. If you buy a variable-rate CD when interest rates are low, there is a good chance the rate will rise over the course of the term. By contrast, if interest rates are high when the CD is opened, it's likely they could go down soon after.

Also, consider what features are most important to you. A variable-rate CD that has a steep penalty for early withdrawal may not be as appealing as a fixed-rate product that has a more relaxed early-withdrawal policy.

As attractive as they sound, variable-rate CDs also come with certain pitfalls. For example, prolonged low interest rates can adversely affect your returns, even if the rates increase later. In contrast, fixed rate CDs are more profitable during such times. Variable-rate CD returns are also susceptible to inflation. This is especially the case during times of high inflation. A CD essentially locks in your funds for a certain period of time. If inflation shoots up during that time period and your returns do not keep pace with it, then the value of your holdings tends to decline on an overall basis.

Example of Variable-Rate Certificates of Deposit

Suppose a certificate of deposit is based on the prime rate or the rate that commercial banks charge their customers. The CD is issued for a three-year term, with a guarantee of principal repayment. During this time, the prime rate decreases from 4% to 1%. The difference in prime rate between the time of issue and maturity (-3% in this case) is the amount due to the holder. If the prime rate moves in the opposite direction (i.e., it increases from 1% to 4%), then the holder profits from the CD.