The prime rate is a bank's lowest lending rate. It is often set at an interest rate spread above the federal funds rate.
The federal funds rate is the overnight interbank lending rate for reserves on deposit with the Fed, and as the minimum rate influences borrowing costs throughout the economy. Many banks change their prime rates in concert with Fed announcements of changes in its fed funds target range.
Changes in the fed funds rate also influence the rates banks offer to attract deposits, including rates on certificates of deposit (CDs). So the prime rate and CD rates are linked because both are based on the fed funds rate benchmark. While prime rates often rise promptly after Fed rate hikes, banks may delay increases in deposit rates, including on CDs, until competitive pressures require them.
- The prime rate is the interest rate that banks charge their best customers for loans.
- Banks set their prime rate as a spread above the risk-free rate they earn on reserve balances deposited at the Federal Reserve.
- Lending rates tend to rise faster than those the banks pay for CDs, but these do increase eventually.
- Some banks offer CD rates well above the national average, making it especially important to shop around before making an investment.
How the Prime Rate Works
The prime rate is the interest rate that banks charge their most creditworthy customers. Though the Federal Reserve reports on the prime rate each weekday, each bank sets its own. What the Fed reports is actually the average prime rate in a sample including many of the 25 largest banks. The prime rate is one of several base rates banks use to price short-term loans.
Changes in the federal funds rate also move the interest rate the Fed pays banks on their reserve balances. For example, when the Fed increased its target for the federal funds by 75 basis points to a range of 1.5% to 1.75% in June 2022, it also increased the interest rate paid on reserve balances by 75 basis points to 1.65%.
When this risk-free rate rises, so do lending rates starting with the prime rate, since lenders still want to get paid for taking on duration and credit risk.
Increases in a bank's prime rate boost its net interest income. A bank's net interest income can be compared with its interest expense and the average size of the assets portfolio to arrive at net interest margin, the core measure of a financial institution's profitability.
As of June 15, 2022 (before the Fed rate hike the same day), the effective federal funds rate was 0.83%, while the bank prime loan rate was 4%.
What Happens to CDs When the Prime Goes Up
When the prime and other lending rates rise they provide banks an incentive to attract lower-cost deposits by paying higher interest on savings accounts and CDs. Conversely, when the prime rate comes down, the interest rates banks offer usually decline as well.
Still, rising rates give banks more room to increase their net interest margin by not raising their deposit rates quite as much or as promptly as the interest rates they charge on loans. For example, the prime rate increased from 3.25% in March 2022 to 4% by May 2022. Meanwhile, average national CD rates on 12-month deposits, reported monthly by the Federal Deposit Insurance Corporation (FDIC), rose from 0.15% in March to just 0.21% in May.
So you may not see CD rates rise immediately in proportion to the increases in the prime loan rate. Eventually, though, the annual percentage yield (APY) on these products would increase as well amid competition for new deposits.
Note that the top rates on CDs offered by individual banks are often much higher than the national average, so it can pay to shop around.
How Rates in the Economy Affect CD Investments
Interest rates on CDs are intertwined with borrowing costs throughout the economy. That becomes especially obvious when interest rates are rising sharply in response to elevated inflation. When the Fed raises its benchmark rate, banks eventually increase the rates they pay depositors. The increased interest helps offset the erosion of the deposited sum's purchasing power as a result of inflation.
In choosing a CD, investors face a tradeoff: longer-term CDs will offer higher interest rates but also have more inflation risk. There is also the greater likelihood that further interest rate hikes will make the rate they pay less attractive, since money locked in a CD today could get a higher rate if locked three months from now instead.
Frequently Asked Questions
Will Certificate of Deposit (CD) Rates Keep Rising in 2022?
It's very likely, yes. The Federal Reserve raised the federal funds rate by 75 basis points to a range of 1.5% to 1.75% in June 2022, and at the time Fed policymakers expected the rate to reach 3.4% by year's end. When the federal funds rate rises, banks historically raise their lending and deposit rates, though not necessarily at the same pace.
Is a CD a Good Investment?
CDs are safe investments because their value doesn't fluctuate and principal in CDs is generally insured by either the FDIC or the National Credit Union Administration (NCUA). Because of their fixed and relatively low interest rates, however, CDs are exposed to inflationary risk.
Do CDs Have Fixed or Variable Interest Rates?
Fixed-rate CDs are more common, but some banks and credit unions also offer variable-rate CDs. Their interest rates are tied to the prime rate or a market index.
The Bottom Line
The prime rate and CD rates are tied through their correlation with benchmark interest rates, including the federal funds rate and the interest rate the Fed pays on bank reserves. When these rise, the prime rate quickly follows, and CD rates tend to increase as well, albeit more slowly. Higher interest rates can be a bright spot for depositors, especially those dissuaded from investing in CDs by their low interest rates in recent years. Inflation, however, can erode their gains in terms of purchasing power.