The relationship between variable CD rates and treasury note rates

Certificates of Deposits, also known as CDs, are fixed term investments of higher amounts which earn a comparatively higher rate of interest. In a fixed CD, the customer could choose to go for the present rate of interest being offered, which will not be increased or decreased during the tenure of the CD. 

What is a variable CD? 

There also is the option of Variable CD, in which the rate of interest applicable to a particular customer’s CD will go up or down according to the respective increase or decrease of the bank’s CD rate regime. Usually Variable CD rates are linked to the country’s Treasury note rates, but there are many other ways of fixing variable CD rates. There are usually two types of variable CDs, one is an indexed CD and the other is a scheduled or non–indexed CD. 

Indexed Variable CD Rates 

As discussed above, the most common type of variable CD has its rate linked to the rate fixed by the federal government, for instance the US Treasury Note or Federal Prime Rate. If your bank is offering a variable CD one hundred basis points higher than the prime rate, and the Federal Prime Rate is 3 percent at the time you invest in a variable CD indexed to the Prime Rate, then your effective variable CD rate at that time would be four per cent. But subsequently if the Federal Prime Rate rises to four per cent then your ROI would also rise to five per cent. Likewise, if the Federal Prime Rate falls to 2 per cent, then your rate would also fall to three per cent. 

Scheduled Variable CD Rates 

Some variable CDs have a predetermined schedule of the rates of interest which is given to you at the outset, and you know that this is how the rate will increase or decrease during the tenure of the CD. These variable CDs are also called non – indexed CDs. Although the ROI changes during the tenure, but this is a fixed rate CD in a certain way because you are already aware of how and when the rates will go up or down. 

Premature Withdrawal 

As in most time deposits, and more so in the case of Certificates of Deposit, there is a heavy penalty to be paid in case of partial or complete withdrawal before the expiry of the deposit tenure. Hence one should ideally opt for a CD only when there is the availability of a substantial sum of money which is very unlikely to be required in the medium term future. But if premature withdrawal is unavoidable, then there are different treatments of the same by indexed and non – indexed variable CDs. If you have invested in an indexed variable CD, then you can escape any penalty only in case the index has fallen below a certain level. In case of scheduled variable CDs, a partial withdrawal is free of penalty only on the dates when changes in the rate of interest are scheduled.

While fixed CDs offer the security of a standard rate throughout the tenure, but it can sometimes disappoint an investor if the federal and other rates rise up substantially, and it is at these times that a variable CD looks even more attractive!