Understanding CD rates is important for any investor interested in maximizing their safe savings dollars. As with savings account rates, the rate on a Certificate of Deposit (CD) varies significantly by bank and by term. By understanding how these instruments work, you can find the best product and rate for you.
What is a Certificate of Deposit?
Certificates of Deposit, commonly referred to as CDs, are bank instruments in which an individual or business deposits money into a bank for a fixed period of time in return for a fixed interest rate of return. The fixed period of time in which a CD is committed to the bank is called the term. If a depositor pulls the money out before the term is over (breaking the CD), then a penalty is assessed. Be sure you understand what this penalty is if you think you might have to break the CD before the term expires.
Standard CDs generally come in the following terms: 3 months, 6 months, 12 months, 18 months, 24 months, 36 months, 48 months, and 60 months. Many banks also offer other, non-standard term lengths (i.e. 13 months).
The rate that a bank provides on a CD depends on three main factors: the Fed Funds rate, bank funding needs, and the term length.
The Fed Funds Rate
One of the key factors in determining bank CD rates is the Fed Funds Rate. Set by the Federal Reserve Bank, the Fed Funds Rate is the rate that banks charge each other for loans. If the Fed Funds Rate drops, then bank rates will follow it down. If it rises, banks rates also follow suit. The Federal Reserve sets the Fed Funds Rate depending on the state of the economy. If the economy is doing well, the rate is set high, if the economy is not growing or in recession, the rate is set low. Bank rates and CD rates follow.
Understanding this can help you choose an optimal CD term. For example, if the economy is doing well but you expect it to slow down in the future, then it might make sense to open a 5 year CD. That will lock your money in at a high rate even if bank rates fall over the next couple of years. If consumers had locked their money into a 5 year CD in 2008 at a rate of over 6% APY, they would have earned that rate well into and through the recession and the historically low interest rates.
If the economy is in a recession or not doing well, but you expect it to improve and hence the Fed Funds rate to rise, then it may be smart to put your money into a short term CD or even a savings account. If rates rise, your money is not locked in at a low rate.
Other investors hedge these changes in interest rates by CD laddering. CD laddering involves breaking your CD investment into different terms so that a CD comes due every year. This smoothes out earnings and helps minimize interest rates changes.
Bank Funding Needs
As the BestCashCow rate tables show, competing banks offer significantly different CD rates on the same term. Banks have different funding strategies and this impacts rates. The cash you deposit into a CD is used by a bank to make a loan or fulfill some other bank need. If a bank has a lot of cash on hand, or isn’t planning to make a lot of loans, it doesn’t have as great a need for deposits and will pay lower rates. By looking at the rate tables, you can get a sense for which banks are willing to pay more for your money. Higher rates are not an indication of bank distress. In fact, research done by BestCashCow shows that banks that pay higher interest on CDs and other account, are generally more stable than their lower rate peers. Nevertheless, BestCashCow recommends that you always stay within FDIC insurance limits (or NCUA limits for credit unions).
Term length also makes a big difference in CD rates. A five year CD will almost always pay significantly more than a 1 year CD. As an investor, you must decide how long you want to lock your money. The decision should be based on personal decisions (do you have a need for the cash) as well as what you think will happen with the economy. If you are thinking about investing in a short-term CD (1 year or less) it also makes sense to compare the rate with the best savings rates. Savings rates will often be higher than the shortest term CDs.
The table below shows the spread or the different between different CD terms and the difference between savings and CD rates over time. The blue line measures the difference between the rates of 5 year CDs and 1 year CDs. As you can see, it varies significantly, from .40 percentage points to 1.6 percentage points. The pink line measures the spread between 3 year CD rates and savings rates. Before depositing money, be sure to understand the premium you are receiving for locking your money up for an extended period of time. If banks are not paying that much more to lock up your money for five years, it may make sense to stay in shorter term CDs.
It is easy to go to the bank and open a CD. What is harder is understanding the factors behind CD rates and using them in your favor to get the best rate possible. By following sites like BestCashCow and educating yourself, you can easily put extra money in your pocket.