How changes in the federal funds rate can affect CDs
One of the primary ways the Federal Reserve works to maintain economic stability is by raising or lowering the federal funds rate. This is the interest rate banks use when lending money to each other. They often use it as a foundation when they decide which interest rates to set for their loan and deposit account customers.
The Fed usually lowers the federal funds rate in response to economic crises to make it more affordable to borrow money. Shortly after the Fed does this, you may see banks begin to lower their rates as well. That's great news for borrowers, because loan interest rates decrease. But it's a blow for savers, who will usually see their savings account rates decrease.
Rates on new CDs will also decline when the federal funds rate declines. However, any CDs you have opened will stay at the same interest rate, because traditional CD rates are locked in for the entire term. There is an exception to this rule: callable CDs. For these CDs, the bank can "call" the CD back and reissue you one at a lower APY if rates have fallen since you opened the CD. If you have one of these, you could see your CD rate drop when the Fed slashes the federal funds rate.
Conversely, when the Fed raises the federal funds rate, loans get more expensive -- but the APYs on deposit accounts like CDs also rise. The CDs you already have won't be affected unless you have a step-up or bump-up CD that raises your rates periodically. But new CDs will likely have a higher APY.
How are CD interest rates determined?
Banks base their CD rates on the federal funds rate, but ultimately each bank sets its own rates. APYs depend on several factors. For example, online banks usually have higher APYs than brick-and-mortar banks because their operating costs are lower.
CD rates also depend in part on the length of the CD term. Typically, CDs with longer terms have higher APYs than short-term CDs. But this can also vary somewhat by bank. Some banks may offer more competitive rates for one CD term than they do for another.
The type of CD also plays a role. For example, no-penalty CDs usually have lower APYs than traditional CDs. That's because you can withdraw your money from a no-penalty CD without paying any extra fees. Step-up and bump-up CDs can also start out with lower rates, though you may be able to make up for this with higher APYs later on. Callable CDs may start with higher rates, but there's always the chance these could drop later.
What to consider if you're looking for a CD
When choosing a CD, here are a few things you should keep in mind:
- APY: APY determines how much money you make, so it's the most important factor when choosing a CD. You don't have to find the highest rate around, but you want to choose one that's among the best.
- Term length: Typical term lengths range from six months to five years, but it's possible to find longer or shorter CDs. Remember, you can't usually touch your money for the full term, so choose carefully.
- CD type: As discussed above, there are different types of CDs. Traditional CDs lock in your rate for the full term. There are also less-common CDs with somewhat-variable APYs.
- Penalties for withdrawal: Most CDs penalize you for withdrawing your funds before the term is up. Each has its own system for determining penalties. Make sure you understand the rules for your CD before you apply.
- Minimum deposit: Some CDs don't have a minimum deposit. Others require a few hundred or a few thousand dollars to open. This is especially important to note if you're interested in building a CD ladder. A high minimum deposit could prohibit you from successfully building a CD ladder due to insufficient funds.
- Variety of terms: If you think you'd like to build a CD ladder, you should look for a CD with a good mix of term lengths.
