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How Do They Determine Interest Rates for Certificates of Deposit?

Interest rates for certificates of deposit or CDs are determined by banks using four primary factors: the amount of the CD, the duration of the CD, the prevailing interest rate environment, and how much the banks believe they can earn from any investments made by their depositors. There is no fixed CD interest rate across different banks for a particular term. One bank may offer a fixed rate for a specific term while another bank may offer something better for the same period of time. It mostly depends on the financial institution with whom you have entrusted your money. To better understand how CD interest rates are determined by banks, it is advisable to look more closely at the different factors one by one.

The amount of a CD is one of the determinants of its interest rate. Banks make money for themselves and their depositors not from the savings from their depositors but from issuing loans to other customers who need substantial amounts for critical purchases such as buying a house or a car. Banks may even use the money themselves to invest in securities, especially those that will guarantee significant returns over time like stocks and bonds. A bigger CD amount means more money that may be loaned out to other depositors or used for the bank's own investments, and more money means greater returns. If a bank is projected to make considerable money from interest earned through both loans and investments, it could endow CD holders with a very favorable rate.

A longer CD duration can also contribute to a higher interest rate. The longer a depositor's money stays with a particular bank, the more time that bank has to use that same amount for issuing loans and exploring every possible lucrative investment opportunity. Banks will in turn benefit from higher interest from their own long-term investments as well as from loans. A bank will use a higher interest rate to encourage depositors to invest in longer-term CDs. It will take much longer before depositors can get their money back, but at least they have the benefit of a much larger return.

Interest rates prevailing in the market have an effect on CD interest rates. The market collectively refers to the various investment markets today which include the stock market, the bond market, the money market which primarily involves short-term fixed-income securities, and the foreign exchange market. A decrease in market interest rates will result in a decrease in the CD interest rates offered by individual banks. Low market rates will not allow banks to generate a substantial return even with bigger principals and longer durations, thus making short-term securities the more attractive investment options. As long as current market rates remain low, issuing banks will declare low interest rates to discourage depositors from investing in long-term CDs.

Profitability also has a hand in determining CD interest rates. Some banks attract more customers by providing rates that are at least marginally higher than those of their closest competitors. It is hoped that a greater number of depositors will result in more money for loan issuances and investments, and one way to entice more and more people into doing business with them is through issuing CDs with more favorable rates compared to other banks.

CD interest rates could either rise or fall and may even come short of depositors' expectations, but one thing is certain. A CD may not always guarantee higher profitability for its owner than with other investment vehicles, but money is kept safe and it will continue to grow until the end of the term. Whatever principal you invest in a CD will definitely come back to you along with a little something extra.

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