When you are trying to make the best investment decisions, it always helps to understand what affects the value of those investments. Bank certificates of deposit are insured by the Federal Deposit Insurance Corporation, so they represent a safe place to put your money. They pay interest according to market interest rates, particularly if your CD pays a variable rate, but CD rates are more likely to affect your bank's prime rate than the other way around.
How Banks Make Money
Banks borrow money from their depositors through CDs, money market accounts, savings accounts and checking accounts. The money you deposit is used by the bank to make loans. Every day's cash deposits are added to the balance already on deposit at the bank. Each account type that pays an interest rate represents a cost to the bank, so the average interest rate paid on all such deposit accounts represents the bank's cost of funds, just like the rates on your credit cards are your cost of funds. When banks make loans, they add approximately 2 percentage points over their cost of funds to cover their expenses for facilities and employees, and then they add more percentage points on top to make the loans profitable. Some borrowers don't pay back their loans, so the extra points charged in interest help to make up for money lost on bad loans. Banks also make money on fees for services they provide.
Why Banks Issue CDs
Certificates of deposit represent attractive sources of funds for a bank because the money stays on deposit at a specified rate of interest for a specified amount of time, unlike MMAs, savings and checking accounts. This specified amount of time is the CD's term to maturity. This makes it easier for the bank to know how much money it can lend to its borrowers. Therefore, banks are willing to pay attractive interest rates on their CDs, but that increases their cost of funds. When the bank's average cost of funds rises, the rates they charge on loans also rises so they can maintain a profit margin. When their cost of funds goes down, so do the rates they charge on loans.
What Is the Prime Rate?
When you hear on the news that the prime rate has been raised or dropped, that refers to a survey by "The Wall Street Journal" of the nation's top ten commercial banks. When 7 out of the 10 banks raise or lower their prime rates, the WSJ reports that the current prime rate has been raised or lowered. Actually, every bank sets its own prime rate. Its prime rate is the rate it charges its most creditworthy business borrowers -- very large corporations. All rates on loans are set based on a formula that considers the prime rate, the type of loan and the credit rating of the borrower.
How the Prime Rate is Set
If a bank's average cost of funds is 3 percent, the bank adds approximately 3 percentage points to that to arrive at the prime rate -- in this example, 6 percent. When you see an advertisement stating that loans to borrowers with good credit are at prime plus 1, that means that the interest rate on the loans the bank makes to small businesses and average individuals with good credit is 7 percent, in this example. So the prime rate doesn't affect the CD rates as much as the interest paid on the CDs affects the prime rate. When the Federal Reserve changes the discount rate, it also affects the bank's cost of funds because the bank borrows cash at the Fed discount window to make up for any shortfalls in deposits vs. withdrawals. So changes in the discount rate also affect the prime rate.
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