How Do They Compute CD Interest Rates?
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How Banks Set Interest Rates
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Banks set interest rates on certificates of deposit (CDs) based on the maturity length of the certificate and how much money they believe they can earn by lending out that money to others. The Federal Funds Interest Rate set by the Federal Reserve is also a major determinant of how high banks will set their CD interest rates. If the Federal Reserve raises rates, commercial banks will raise CD rates and vice versa.
Customer Retention and CDs
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Banks often offer CDs with higher interest rates to existing customers of other bank services or to individuals with high bank balances, large mortgages or other such loans. They do this to encourage customers who might otherwise shop at other banks for CDs with higher rates to instead invest their savings with their primary bank. A bank also may temporarily increase interest rates on CDs if they need to raise their deposits on hand in a short period of time.
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Profits on CDs
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Banks make money from CDs by using them as an underlying asset against which they make loans. They are able to pay a higher interest rate on CDs than savings accounts because they can predict when the CD will be liquidated, making it a more stable asset than a savings account that the consumer can withdraw from at any time. The higher profits that banks make off of their loans, the more they can pay in CD interest. If interest rates are generally low and loan default rates are high, interest payments on CDs will decrease, since loan profits are relatively low in such a financial climate.
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