Do CD Rates Go Up When the Prime Goes Up?

The prime rate does not directly influence rates offered on certificates of deposit (CDs), but it is related. The prime rate is a lending rate used by banks for their very best commercial customers, and it's usually based on the Federal Reserve's federal funds rate.

CD rates are also influenced by the fed funds rate, but also by other factors such as inflation, the economy, competition, and each bank or credit union's individual situation. When prime rates rise, shop around for the best CD rates available.

How the Prime Rate Works

The prime rate is the interest rate banks charge their most creditworthy institutional customers. This is a lending rate. Each bank sets its own prime rate. The U.S. Federal Reserve collects weekday average prime rates of the 25 largest banks. But the prime rate most often cited is the one the Wall Street Journal reports daily. Researchers there survey 10 of the largest U.S. banks and come up with an average based on their rates.

Banks set their prime rates based partly on the federal funds rate established by the Fed. The federal funds rate is what banks charge each other for short-term loans. Often, banks set their prime rate three percentage points above the fed funds rate.

Changes in the fed funds rate also influence the rates banks offer to attract deposits, including rates on certificates of deposit (CDs). So the prime rate and CD rates are linked because both are based on the fed funds rate benchmark.

While prime rates often rise promptly after Fed rate hikes, banks may delay increases in deposit rates, including on new CDs, until competitive pressures require them to do so. During the COVID-19 pandemic, many banks were deposit-heavy because consumers were saving money they couldn't spend on things like going out to eat. There wasn't much competition to attract new deposits. As a result, CD and other rates didn't rise dramatically when the Fed began raising rates in 2022, according to research from S&P Market Intelligence.

But by the end of 2022, some banks began paying higher interest on savings accounts, particularly CDs. Changes depended on the institution. Some didn't raise rates at all or only a bit. Others offered higher CD rates specifically to attract new deposits, stem outflows of cash due to competitor rates, or help boost their loan-to-deposit ratios—a key measure of a bank's liquidity.

What Happens to CDs When the Prime Goes Up?

Rising rates can give banks more room to increase their profits (also known as their net interest rate spread). The banks do so by not raising their deposit rates quite as much or as promptly as their loan interest rates.

For example, here's how the federal funds rate and the prime rate increased alongside CD rates on 12-month deposits in the 14 months during which the Fed raised rates 10 times.

You may not see CD rates rise immediately in proportion to the increases in the prime loan rate. Eventually, though, these products' annual percentage yield (APY) should also increase amid competition for new deposits, at most banks.

Note that the top rates on CDs offered by individual banks and credit unions are often much higher than the national average. So it makes sense to shop around.

How Rates in the Economy Affect CD Investments

CD interest rates' relationship to overall borrowing costs is obvious when interest rates rise sharply in response to elevated inflation. When the Fed raises its benchmark rate to try to cool spending and fight inflation, banks may increase the rates they pay depositors. The increased interest you earn helps offset the erosion of your deposits' purchasing power due to inflation.

But not fully. For example, the Consumer Price Index average inflation rate increased by 4.9% for the 12 months ending April 2023. If you put your money in an average-earning CD in April 2022, you would have only averaged a 0.17% return in the previous 12 months. You lost significant purchasing power due to inflation. In addition, you'll pay taxes on any interest earned by the CD.

When choosing a CD term length, investors face a tradeoff. Longer-term CDs may offer higher interest rates. But today's rate may be less attractive if rates keep rising. Money locked in a CD today could get a higher rate three months down the road. If you think rates will continue rising, you may want to look into buying a bump-up CD or setting up a CD ladder.

The Bottom Line

The prime rate and CD rates both correlate with the benchmark federal funds rate set by the Federal Reserve. When the fed funds rate rises, the prime rate quickly follows, and CD rates tend to increase as well, albeit more slowly and by a limited amount.

Higher interest rates can be a bright spot for depositors previously uninterested in investing in CDs with low yields. Inflation, however, can erode depositors' gains in terms of purchasing power. Consider inflation's risks and whether you think rates will continue rising before locking up money in one longer-term CD.