What Is a Variable-Rate Certificate of Deposit (CD)?

A variable-rate certificate of deposit (CD) is a type of savings account offered by banks and credit unions. Also sometimes called a "flex CD," this certificate locks up your money for a fixed length of time (term) but provides a fluctuating interest rate based on different factors such as the prime rate, the Consumer Price Index (CPI), Treasury bills, or a market index. The Federal Deposit Insurance Corp. (FDIC) protects variable-rate and other CDs.

Understanding a Variable-Rate CD

A variable-rate CD allows investors to put their money into a secure, protected account where it will earn interest over the life of its term. The earned interest is usually inaccessible to the account holder until the CD matures. Variable-rate CDs tend to have both limited choices of terms and longer terms, such as a 12-, 24-, or 36-month term.

Finding a variable-rate CD can also be more challenging compared to other CD types. You may need to research options at smaller or community banks and credit unions. A variable-rate CD pays an interest rate that can go up and down throughout the life of the security. The exact factors determining the interest rate of a variable-rate CD will vary depending on the institution. A bump-up CD could be considered a type of variable-rate CD and is offered by more banks and credit unions. With a bump-up or step-up CD, rates only go up, not down. But typically, you must initiate the change, and there are limits on how many times the rate can change (usually only once or twice).

In contrast to either a variable or step-up CD, the widely available fixed-rate CD has a locked-in interest rate, so the rate remains the same throughout the entire term. Fixed-rated CDs tend to offer more terms to choose from, such as 3-month to 5-year CDs.

A CD is generally considered one of the safer ways to invest your money, especially as your money is insured by the FDIC, up to $250,000. 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 preferable, but consumers comfortable with increasing the risk just a little bit may want to consider a variable-rate CD if rates are predicted to rise.

Special Considerations of a Variable-Rate CD

When considering a CD with a variable interest rate, remember a few things. First, these CDs generally have the most significant profit potential if interest rates are low, with a good chance rates will rise over the term. By contrast, if interest rates are high when the CD is opened, it’s possible that they could go down soon after and take your returns lower, too.

Also, consider what features are most important to you. A variable-rate CD with a steep penalty for early withdrawal may not be as appealing as a no-penalty CD with a more relaxed early withdrawal policy.

As attractive as they sound, variable-rate CDs also come with certain pitfalls. Prolonged low interest rates, for example, can adversely affect your returns, even if the rates increase later. In contrast, fixed-rate CDs may be 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 period and your returns do not keep pace with it, the real value of your holdings declines.

Example of a Variable-Rate CD

Meilee wants to park her money in a variable-rate CD, and spends time researching where it's possible to do so at a higher rate. She finds a 12-month CD that offers a variable, competitive rate based on the Federal Reserve’s federal funds rate minus 0.25%. The Federal funds rate is 2.50% when she opens the account, so she will earn 2.25% APY to begin with.

Meilee thinks rates will go up, and so puts $1,000 into the variable-rate CD. Meilee's friend Amy puts $1,000 into a traditional 12-month CD at the same time as Meilee; the CD offers a 3% interest rate. After only one month, the federal funds rate increases to 3.25%. Meilee's variable-rate CD now earns 3%, the same as Amy's. The Fed rate continues to increase over the next six months until it is at 4.75% in September. Meilee earns 4.5% in interest in September. Amy is still earning 3% in September.

But imagine if Meilee was wrong, and the federal funds rate declined to 2% after six months. Meilee would only earn 1.75% on her CD, while Amy would still be earning 3%.

The Bottom Line

Variable-rate CDs provide a variety of benefits to people looking for a secure, protected investment that will earn a relatively modest amount of interest if rates are rising. Remember that the earned interest is usually inaccessible to the account holder until the CD matures. 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. Your rate (and returns) could also fall if benchmark rates decline. In contrast, fixed-rate CDs are more profitable during such times.