What it means
A certificate of deposit, or CD, is a deposit held for a set period, such as one or five years, which the saver agrees not to withdraw early without a penalty. In return, the bank typically pays a higher rate than on an ordinary savings account.
With a variable rate CD, the rate is reset at regular intervals, such as monthly or quarterly, according to a benchmark such as a Treasury bill rate or a bank's prime rate. The reset dates and the benchmark are written into the terms when the account is opened.
The attraction is protection against rising rates. A saver who buys a fixed CD and then sees market rates climb is stuck with the lower return, whereas the holder of a variable CD sees the payment move upwards.
The opposite happens when rates fall, and the saver's income shrinks. Because of this uncertainty, the initial rate on a variable CD is often similar to or lower than the fixed rate on a comparable CD, and the saver is betting on future moves.
The product suits people who expect rising rates but still want the discipline and safety of a term deposit. Deposits at insured banks are protected up to the legal limit, but the limit and rules differ by country, so it should be checked at the time.
Companies with spare cash also use variable CDs, and the treasurer should compare them with fixed deposits, money market funds and other short-term options. Early withdrawal penalties and the frequency of resets are details that can change the real return.
In practice
Real-world examples.
Example
A retired couple put $50,000 into a two-year variable rate CD because they expect interest rates to rise. After a year, the rate has risen by 1 percentage point, and their income increases. They are glad they did not lock a fixed rate.
Example
A small company has $200,000 set aside for a tax payment in 18 months. The treasurer chooses a variable rate CD to earn interest while keeping the money safe. The company knows the date and the amount it needs.
Example
A parent saving for a child's university fees compares a fixed and a variable CD. The fixed rate is slightly higher at the start, but the variable rate is linked to a benchmark that has been rising. She chooses the variable CD to benefit from further rises.
Formula
Calculation
Interest for a period = Principal x Annual rate for that period x (Months in period / 12)
A saver deposits $100,000 in a variable rate CD that resets each quarter. In the first quarter the rate is 4.00%, so interest = 100,000 x 0.04 x 3 / 12 = $1,000. In the second quarter the rate rises to 4.80%, so interest = 100,000 x 0.048 x 3 / 12 = $1,200. Total interest for six months = 1,000 + 1,200 = $2,200. A fixed six-month CD at 4.20% would have paid 100,000 x 0.042 x 6 / 12 = $2,100, so rising rates gave the variable CD an extra $100. Had the second-quarter rate fallen to 3.60%, the variable CD would have paid only $900 for that quarter, a total of $1,900. Compounding is ignored here for simplicity.Case study
Seen in the real world.
This illustrative case involves a fictional charity, Greenfield Youth Trust, which received a $400,000 grant to be spent over the following two years. The finance officer wanted a safe place for the money in the meantime.
Interest rates were rising, so she split the grant between a fixed CD paying 4.0% and a variable CD starting at 3.8% and resetting every quarter against a benchmark. Over the two years, the benchmark rose and then eased, and the variable CD's average rate came to 4.5%.
The fictional charity earned about $2,000 more over the two years on the $200,000 in the variable CD than it would have in the fixed one, but the officer noted that the result could easily have gone the other way. She reported to the trustees that the split had reduced the risk of being wrong.
Watch out
Common mistakes.
- Assuming the rate will only go up. The rate can fall as easily as it rises, and the income may drop below that of a fixed CD.
- Ignoring early withdrawal penalties. Taking the money out before the term ends can cost interest, so the cash should not be needed in the meantime.
- Not checking the benchmark and reset schedule. The terms decide how closely the rate follows the market and how quickly it adjusts.
Questions
People also ask.
How is a variable rate CD different from a fixed rate CD?
A fixed CD pays one rate for the whole term, while a variable CD changes its rate at set dates in line with a benchmark.
Is my money safe in a variable rate CD?
Deposits at insured banks are generally protected up to a legal limit, but the limit and the rules vary, so check the details.
When might a variable rate CD be a better choice?
It can be better when interest rates are expected to rise, or when the saver wants to avoid locking in a low fixed rate.
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