The prime rate is a key factor in determining the interest rates that banks charge for many types of loans. It can also impact the interest rates they pay on products like certificates of deposit (CDs). Here is how the prime rate affects CD rates.
- The prime rate is the interest rate that banks charge their best business customers for loans.
- Banks set their prime rate based in part on how much it costs them to acquire funds from the Federal Reserve and other sources.
- When their "cost of funds" rises, their prime rate will rise, too.
- Banks use their prime rate to determine how much they will charge for loans. Increases or decreases in their prime rate can also affect the interest rates they pay on deposit products, such as CDs.
How the Prime Rate Works
The prime rate is the interest rate that banks charge their most creditworthy business customers. Though the Federal Reserve reports on the prime rate each weekday, the rate itself is determined by individual banks. What the Federal Reserve reports is actually the average prime rate set by most of the 25 largest banks.
A bank's prime rate depends in large part on its average cost of funds, or what it pays the Federal Reserve and its depositors to acquire money to lend. Let's say a bank has an average cost of funds of 3%. It might then add another 3% to arrive at a prime rate of 6%. In that case, if the bank charges a particular borrower "prime plus 2," it's charging a rate of 8%.
When the Federal Reserve changes its discount rate (the minimum interest rate it charges banks to borrow money), that affects the bank's cost of funds. So, any changes in the discount rate will also affect the prime rate. When the discount rate goes up, a bank's prime rate will go up with it.
As of April 22, 2022, the federal discount rate was 0.50%, while the prime rate was 3.50%, according to the Federal Reserve.
What Happens to CDs When the Prime Goes Up
When the prime rate goes up, the interest rate on new loans will go up with it. The interest on savings vehicles like CDs can go up too because banks now have an incentive to pay more to obtain money from depositors. When the prime comes down, the interest on lending products and savings vehicles can go down with it.
In other words, when the prime rate is high, it costs consumers more to borrow on mortgages, lines of credit, and credit cards. When the prime rate is low, it costs them less to borrow.
The effect on CD rates is less direct. You won't necessarily see CD rates change immediately after an increase or decrease in the Fed's discount rate. That's because it often takes weeks to months for banks to make changes to their savings products. Eventually, though, the annual percentage yield (APY) on these products should rise or decline.
How Rates in the Economy Affect CD Investments
Interest rates on CDs and interest rates in the economy at large are intertwined. That becomes especially obvious in times of inflation when interest rates are rising sharply. If the Fed raises its discount rate in response, banks will often follow suit, raising the rates they pay depositors. However, though depositors might be earning more interest on their CDs, they may not really be coming out ahead in terms of purchasing power.
So, when they choose a CD, investors face a tradeoff: The longer the term of a CD, the higher the interest rate they may receive but the greater the risk that inflation will erode their money's purchasing power in the meantime.
Will Certificate of Deposit (CD) Rates Increase in 2022?
It's very likely, yes. The Federal Reserve raised the federal funds rate by 0.25% in March 2022 and projected the rate may reach 1.9% by year's end. When the federal funds rate rises, banks historically pass the increase onto consumers by raising interest rates across the board, charging more for loans, and paying more to depositors.
Is a CD a Good Investment?
CDs are safe investments because they don't fluctuate, are generally insured by either the Federal Deposit Insurance Corporation (FDIC) or the National Credit Union Administration (NCUA), and have historically steady returns. Because of their fixed and relatively low interest rates, however, CDs do face inflationary risks.
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 can be a factor in setting CD rates. When it rises, CD rates tend to as well. Higher interest rates can be a bright spot for depositors, especially those who have been dissuaded from investing in CDs due to their low interest rates in recent years. Inflation, however, can reduce their gains in dollar terms.