How Interest Rates Affect Savings and CDs

Interest rates determine the annual percentage yield earned on bank savings accounts and certificates of deposit. When the Federal Reserve raises rates to control inflation, savings and CD yields follow with higher returns. Understanding the connection allows planning around rate cycle impacts optimizing idle cash earnings.

What are Interest Rates?

Interest rates represent the cost of borrowing money expressed as an annual percentage charged on loans:

Banks pay interest as an incentive for consumers and businesses to deposit money with them.
Depositors earn interest income on cash balances in their accounts.

Higher interest rates allow banks to increase yields paid on savings products like high-yield accounts and CDs.

Savings Account Interest Rates

Interest rates paid on regular bank savings accounts historically average:

Less than 0.1% during prolonged low rate environments
Around 0.5% during periods of rising rate cycles
1% or more when rates peak at higher levels

Online and jumbo savings accounts pay rates competitive with CDs depending on the rate environment.

How the Federal Reserve Impacts Interest Rates

The Federal Reserve (The Fed) directly influences interest rates through monetary policies:

Fed Funds Rate – Interest rate at which banks borrow and lend reserves to each other overnight. Target range set 8-10 times a year by Federal Open Market Committee (FOMC).
Discount Rate – Interest rate charged to commercial banks for short term lending directly from Federal Reserve banks. Changes follow the Fed Funds rate.

By raising these key rates, the Fed tightens availability of money and credit during strong economic expansions to control inflation. Other interest rates follow accordingly based on the higher cost of money.

Treasury Yields Also Guide Interest Rates

Outside of Fed policy, Treasury bond yields provide key benchmarks guiding consumer savings and borrowing rates. Treasury yields rise based on higher Fed rates and bond demand.

Key Treasury rates include:

3-month and 6-month bill yields
2-year and 10-year note yields
30-year bond yields

As Treasury yields rise amid Fed tightening, deposit interest rates eventually follow.

How Changing Interest Rates Impact Savers

For savers, higher interest rates allow:

Greater earnings on savings accounts and CDs
Higher yields on low-risk money market mutual funds
Greater returns on newly issued bonds trading at elevated coupons
Ability to find undervalued bonds trading below par as rates increase

Rising rate cycles enable growing idle cash through savings, bond ladders and CD portfolios.

Deposit Rate Lags Behind Fed Moves

While savings interest eventually increases with higher rates, increases lag significantly behind the Fed’s actions.

Banks hesitate boosting deposit rates immediately to capture larger interest rate spreads as their lending income incrementally grows.

But over time, competition forces banks to raise savings yields drawing in more depositors. Patience pays off.

Shopping CD Rates as Interest Rises

During rate hike cycles, continually review CD rates across terms:

Compare top paying 1, 3 and 5 year CD yields as rates increase
Match CD terms to your timeline avoiding tying up money past when you need funds
Be strategic on timing – don’t lock rates too soon ending up below rising market rates
Evaluate early withdrawal penalties and make large deposits if planning to exit CDs prematurely

Proper CD timing as rates rise incrementally leads to capturing peak interest earnings.

Impacts of Falling Interest Rates on Savers

When the Fed cuts rates to stimulate slowing economic conditions, savers earn less:

Savings account yields decrease in tandem with Fed rate drops
Matured CDs roll over into lower renewing rates
Bonds and bond funds decline in value as new issues carry lower coupons

Falling rates leave savers earning diminished “safe” yields across accounts and fixed income assets.

Offsetting Lower Savings Rates

As rates decline, offset reduced income through:

Moving funds into high-yield savings accounts maintaining slightly better rates than national averages
Buying bonds directly holding until maturity dates avoiding principal losses from rate increases
Holding some longer-term CDs with higher locked rates throughout declines
Investing partially in dividend stocks less sensitive to rate moves

How Interest Rates Impact Borrowers

For borrowers, higher interest rates mean:

Increased credit card interest charges on revolving balances
Higher loan rates for mortgages, auto loans and personal loans
More costly adjustable-rate debt as payments reset higher
Potentially tighter loan approval if debt burdens appear less affordable

Rising rates transfer wealth from borrowers to savers over the economic cycle.

How Falling Rates Help Borrowers

When rates decline substantially, borrowers benefit from:

Lower annual percentage rates on credit cards, saving on revolving debt
Cheaper mortgages refinancing existing loans or buying new homes
Lower interest costs on adjustable-rate debts as payments fall
Greater consumer spending power with reduced debt service burdens

Falling rates aid borrower repayment of debts.

Closing Thoughts

While savings returns fluctuate based on economic cycles, recognizing the connection between Fed policy, Treasury yields, and deposit rates helps maximize cash earnings. Compare banks continually as rates rise, seeking the best yields. Understand tradeoffs between liquidity and locking gains. With awareness, savers can prosper regardless of rate direction over time.