Variable-Rate CD – 4 Pitfalls
A variable-rate certificates of deposit (CD) is not new, but they may seem like an especially appealing concept in today’s relatively low-interest-rate environment. Unfortunately, the numbers behind these products don’t always add up to a good deal for savers.
What is a variable-rate CD?
While most CD rates are fixed for the length of the term, variable-rate CDs have interest rates that can change, either according to a prearranged formula based on an index, or at the customer’s option when rates rise. A couple of factors make these accounts seem compelling:
- CD rates remain low. According to recent FDIC figures, the average rate for a one-month CD is just 0.09 percent, which is lower than the average rate for money market accounts, which is 0.13 percent.
- The time premium has all but disappeared. If you are willing to commit to a longer term CD, you are generally compensated for that commitment with a higher rate. However, this premium for longer commitments is still somewhat small. The average rate for a two-year CD is 0.6 percent, according to the FDIC.
A variable-rate CD can be a way of making sure you do not find yourself locked into low rates in the event that rates rise.
The trouble with variable-rate CDs
Though the idea of flexibility sounds good right now, the numbers offered on variable-rate CDs don’t necessarily add up in your favor. Here are four reasons why:
- You may pay a price for variability. CDs that give you the option of a “bump-up” in rates if yields rise before the CD term expires generally make you pay for that option in the form of a lower initial rate. When you compare these rates with standard CD rates, you may conclude that the option is not worth the price.
- Early withdrawal penalty may be cheaper. It depends on the size of the penalty, but in some cases the early-withdrawal penalty on a CD represents just a few months’ interest. That may turn out to be less than the cut in rates you would get on a bump-up or adjustable CD, and you would only pay the price if rate changes made it worthwhile.
- Adjustable value decreases with time. If you do accept a lower initial rate, keep in mind that the longer it takes for rates to rise, the less valuable the bump-up or adjustable option becomes. The more time goes by, the longer you are stuck in a substandard rate, and the less remaining time you have to benefit from a rate bump.
- Losing ground to inflation. Indexed CDs may tout the fact that your principal is guaranteed, so the worst that can happen is that you earn no interest if the index does not move in your favor. However, earning no interest while inflation creeps forward is effectively the same as losing money.
Most types of financial instruments are not inherently good or bad–it is the specific terms that determine how favorable they are. So if you consider a variable-rate CD, make sure that the numbers allow that idea to work for you over the time horizon you expect to hold the CD.
