What is a Variable-Rate Certificate of Deposit?
A variable-rate certificate of deposit (CD) is a financial product that is offered by commercial bank institutions and credit unions that allows customers to deposit and save their money for a fixed period of time with varying interest rates.
How Variable-Rate CDs Work
Variable-rate certificates of deposit are a form of certificate of deposits with an interest rate that fluctuates over time. They are a type of security for depositors to invest their money safely.
The distinguishing factor for variable-rate CDs is that the interest rate will fluctuate over the term of the security, which can provide a benefit to depositors in periods of high interest rates. However, it can raise a significant risk in periods of low interest rates.
The factors behind a variable certificate of deposits’ interest rate are:
- Prime rate
- Market index levels
- Treasury bill yields
Variable-rate certificates of deposit, like regular certificates of deposit, allow depositors to save their money in a secure account while receiving a higher amount of interest than they would generally receive from other accounts, such as demand deposit accounts. A demand deposit account is a savings account that allows the depositor to withdraw their funds at any time.
Variable-rate certificates of deposits also allow banks to obtain secured deposits that they can lend out to borrowers at a higher interest rate.
Benefits of Variable-Rate CDs
Variable-rate CDs offer investors a safe opportunity to generate a relatively high yield on their investments. The securities are in high demand in periods of low interest rates due to the fact that there is a high probability of interest rates rising after the CD is purchased. In contrast, when interest rates are high, variable-rate CDs are in low demand since the probability of interest rates continuing to go up are low.
Downsides of Variable-Rate CDs
A potential issue for depositors is that interest rates will remain low for a prolonged period of time. It can adversely affect the depositor’s overall rate of return. In such periods of time, fixed-rate certificates of deposit are much more attractive.
Certificate of Deposits Explained
A commercial bank or credit unions’ main source of funding comes in the form of deposits from customers. It is also the cheapest form of funding since the interest rate paid on deposits is generally on the lower end of the yield curve.
A bank’s business model is to borrow money in the form of deposits, compensating depositors with a certain interest rate; then, the bank will lend out the deposited money to borrowers in return for a higher interest rate.
Banks and credit unions face a significant risk of their depositors withdrawing their money. Since the bank lends out a lot of the money that is deposited, it may face liquidity risks – essentially, not possessing enough funds to pay depositors when they withdraw. There are a few ways a bank hedges or mitigates such a risk.
First, the bank will borrow from as many separate and unrelated individuals as possible. It diversifies the risk since the probability that every depositor will want to withdraw at one time is low. Therefore, the bank can use newly deposited money to fund withdrawals from old depositors.
A second way a bank can mitigate the risk is by keeping a certain level of money in its reserves just in case. It is typically referred to as a reserve ratio, which is the amount of reserve funds that a bank holds in proportion to total deposits – represented as a percentage. After the 2008 Global Financial Crisis, a new regulatory framework known as Basel III was instituted. The framework held financial institutions to higher reserve requirements in the form of various capital ratios.
Lastly, a bank can mitigate the risk of depositors withdrawing their funds with a fixed-term certificate of deposit. They are deposited funds that customers deposit, and they agree that the funds are to be held for a fixed amount of time and cannot be withdrawn by depositors unless they pay a penalty fee.
In exchange for depositing money for a fixed amount of time, the depositors are compensated with a higher interest rate than they would otherwise receive in demand deposits or money market accounts. Because demand deposits allow depositors to withdraw their money at any time they wish, they do not need to forgo the use of their money.
On the other hand, fixed-term deposits need to forgo the ability to withdraw and therefore, will be compensated for that. Certificates of deposits are also known as time deposits, with longer-term deposits paying higher interest rates.
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