When it comes to stashing your money at a bank, traditional savings accounts usually don't offer the best interest rates. Banks provide a variety deposit accounts, including certificates of deposit or CDs, which typically pay more interest than standard savings accounts. The interest rates banks offer on CDs and other types of deposits can change based on how the U.S. Federal Reserve sets its interest rate policy.
Federal Rate Cuts
The Federal Reserve serves as the central bank of the United States and is tasked with supervising and regulating banks to make sure that the financial system is stable. The Fed uses a variety of tools, including the ability to alter the federal funds rate, to affect the banking system and the state of the economy. The federal funds rate is the interest rate banks charge each other to borrow reserves.
The Fed can cut the federal funds rate in an effort to reduce interest rates in the overall economy. When the federal rate falls, the prime rate -- a benchmark rate banks use to help set interest rates on their products -- also tends to fall. The rates banks offer on CDs are tied to the prime rate, so Federal rate cuts typically cause interest rates on CDs and other deposit accounts, like money-market accounts and traditional savings accounts, to decline.
When you sock cash into a CD, you typically have to wait until a certain maturity date before you can access that money without being hit with a penalty. CDs can last anywhere from a few months to a few years: Accounts with longer terms tend to offer higher interest rates. Cash in a CD typically grows at a fixed interest rate that is determined when you first open the account. With a fixed-rate CD, the interest rate doesn't change after you open your account, even if the Fed cuts the federal funds rate.
Fixed-rate CDs let you lock in a given interest rate. Stashing cash in a CD can be especially advantageous if interest rates are falling or the Fed is expected to cut rates. On the other hand, putting cash in a CD might not be a good idea if interest rates are on the rise, because you'll tie up your cash in an account that will be stuck at a relatively low interest rate.
- U.S. News and World Report: 6 Things to Know About the Fed Rate Cut
- ABC News: Fed 101: How Rate Cuts Affect Consumers
- CNN Money: Smart Banking and Saving Basics
- Federal Deposit Insurance Corporation: Certificates of Deposit -- Tips for Savers
- Federal Reserve Bank of San Francisco: Ask Dr. Econ
- Federal Reserve: What Is The Purpose Of The Federal Reserve System?
Gregory Hamel has been a writer since September 2008 and has also authored three novels. He has a Bachelor of Arts in economics from St. Olaf College. Hamel maintains a blog focused on massive open online courses and computer programming.