Financial institutions use the money they take in from their depositors, including those with checking and savings accounts and Certificates of Deposit, to make loans to other individuals and businesses. The longer savers are willing to leave their money on deposit, the longer the institution can in turn lend that money to its borrowers.

Since borrowers are willing to pay a higher interest rate for longer term, compared to shorter term loans, banks and credit unions will offer higher interest rates to those who loan them money for longer periods.

Setting short-term CD rates

The interest rates paid on short-term CDs, usually those with a guarantee period of a year or less, are generally pegged to the Federal Funds Rate. This is the rate which member depository institutions of the Federal Reserve charge each other for overnight borrowing.

The Federal Reserve’s Open Market Committee sets the target rate for these funds in response to changing economic conditions, in keeping with its mission of “conducting the nation's monetary policy by influencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates.”

To maintain stable prices, meaning low inflation, the Committee lowers or raises its target for the Federal Funds rate. The lower the target rate, the lower the cost or “cheaper” it is to borrow money. Making it “cheaper” to borrow money helps to stimulate business activity during economic downturns.

The converse is that when economic activity is on the rise, inflation tends to set in, diminishing the purchasing power of the nation’s money supply. When that happens, the Committee raises the target rate, making it more expensive to borrow money, slowing down business activity and lessening the threat of inflation.

When setting the target rate, the Committee takes into account, among other factors: the CPI, or Consumer Price Index, published by the Bureau of Labor Statistics, which focuses on the price movements of three broad expenditure categories, Food, Energy, and All items less food; the Unemployment Rate; consumer and business spending and economic forecasts.

If you are interested in investing in short-term CDs, keeping track of trends in these indicators may useful in guiding your thinking as to whether short-term interest rates will be rising, falling or staying steady.

Long-term CD rates

The Federal Funds Rate affects interest rates less for longer-term CDs than for shorter-term CDs. This is due in large measure to the additional risk that financial institutions take on when they commit themselves to paying their depositors a guaranteed interest rate for a lengthy period of time.

To counter this risk, financial institutions examine long- term, rather than short-term trends, using these to make forecasts about the future directions of interest rates and setting interest rates on long-term CDs accordingly.

United States Treasuries are a frequently used benchmark against which banks set long-term CD rates. The interest rate on these obligations of the United States government are not set by the Federal Reserve, but are instead determined by market forces and represent the market’s thinking about the direction of interest rates.

Supply and demand for loans affects CD interest rates

In addition to forecasting the direction of interest rates, banks and credit unions take into account customer demand for loans. If very few are interested in borrowing money at current interest rates, banks will lower the interest rate they charge on loans. However, offering their borrowers loans at lower interest rates translates into lower CD interest rates that banks can pay their depositors.

On the other hand, when there is an increase in demand for loans, financial institutions are able to charge borrowers a higher loan interest rate. Then, in order to attract more depositors to fund these loans, they will raise the interest rate they pay on CDs.

Competition affects CD interest rates

Banks and credit unions also have to take into account the competition they face for depositor’s money. To attract more depositors an institution can raise the interest rate it pays. Other banks may than feel obligated to raise the interest rate they pay or risk having depositors go elsewhere.

An institution may also offer borrowers lower, more attractive loan rates, in order to increase its loan operations, but, to remain profitable, it will then have to offer its depositors lower interest rates on their savings accounts and CDs. Lower rates will attract fewer depositors, so this strategy may not work for long.

Competition for depositor’s money is not limited to other banks or credit unions. Besides being a benchmark for setting interest rates, Treasuries may be an alternative for those who are considering investing in CDs. Therefore, in order to remain competitive, CD interest rates will usually track the interest rate of U.S. Treasuries.

Check BestCashCow to Compare CD rates

Due to institutions pursuing different strategies, the interest rates they offer on both short and long term CDs may vary. That makes it important to always check the offers from a variety of banks and credit unions. You’ll find the best CD interest rates offered nationally and locally on BestCashCow.

CDARS is a service provided by select banks that allows you as a depositor to get up to $50,000,000 in FDIC insurance for Certificates of Deposit. The system works by distributing your deposits to other banks in the CDARS network so that no one bank holds over the maximum amount insured by the FDIC. The FDIC currently insures your deposits only up to $250,000 in deposits per ownership class at a single financial insitutions. This insurance covers all deposits (savings, checking accounts, etc.) in addition to CDs at that particular institution.

For the customer, this process is seamless.

Here's an example of how CDARS works:

• You walk into your bank with $2,000,000 you want to deposit into a 3-year CD.
• They quote you a rate and tell you it will be distributed via the CDARS network. You agree and sign the consent form.
• After you make the deposit, the money is broken up into denominations of less than $250,000 (so that accrued interest is covered) and then distributed to other participating banks that are FDIC insured. Therefore, $2 million might be divided among 9 or 10 banks, instead of 8.
• Your money collects interest, and is fully FDIC protected. You receive a statement from the original bank where you made the deposit.
• When your CD expires, you can go to the original bank and withdraw the full amount or roll the money over for another period.

The Benefits of CDARS

• Up to $50,000,000 in FDIC insurance. Using CDARS you can insure up to $50,000,000 with the FDIC.
• One Bank. There is no longer any need to run around to different banks opening accounts to ensure your money is fully FDIC insured.
• One Statement. You receive one statement from the original bank.
• One Rate. You receive one rate regardless of how many banks are used to insure your money.

The Disadvantages of CDARS

• Potentially lower rate. You will likely receive a much lower rate because CDARS charges banks a transaction fee. Banks often pass this fee on to their customers in the form of a lower rate. Banks may waive this fee for good customers, but you will likely be much better off unless you are super wealthy by dividing your money yourself among the leading CD rates on BestCashCow.
• Lack of Certainty. You do not get to choose which banks your funds are sent to nor do you even know. The only thing you do know is that every bank that accepts your deposits will be FDIC insured.

A close friend of mine who is an expert on financial fraud once explained to me that fraud is most prevalent not when times are especially good or bad, but when large parts of the population are anxiously looking for even just slightly better financial performance than the norm. While savings and CD rates have been held at extreme lows for an unprecedented time due to the Federal Reserve’s intervention, we are now beginning to see some slightly more interesting CD rates. However, people’s frustration over earning so little on their cash and their anxiety to earn more may now be opening the door to web fraud in the certificate of deposit space.

In fact, as CD rates start to head up, there is at least one website that is buying Google Adwords related to “Best Cash Cow” and “Bank rate” and claiming to be offering better rates on CDs than those found on BestCashCow.com.

The website, whose name I will not list here because of the risk of inadvertently providing it with a valuable link, lists an office address on Wilshire Boulevard in Beverly Hills, an 800 phone number and a series of CD rates for 1, 2, 3 and 5 year CD products all of which are better than the best prevailing rates. For example, the site claims to be offering a 5 year CD at 3.09%, while the best rate is currently 2.30%.

The website also misspells several key terms and seems to be written by a non-English speaker, containing numeric and financial terms that make no sense to an American. Nonetheless, some may be frustrated enough or fooled enough to call.

Out of curiosity, I called the 800 number and was transferred to a man who was clearly an American (although given the quality of the phone call, I believe that he was in China or Thailand) who claimed that he could offer these rates on FDIC-insured CDs from banks like Barclays, GE and East West Bank because they are brokered CDs.

To be clear, brokered CDs are a real financial product, ordinarily offered through major investment banks and some online brokerages (such as TD Ameritrade and Fidelity). These products offer account holders at those institutions the opportunity to divide up their money among FDIC insured banks within the umbrella of their investment banking or online banking accounts. In 2008 and 2009, a safe strategy executed quickly by many was to move any free cash from an investment bank’s money market account into short term brokered CDs.

Brokered CDs, however, have never offered rates at or above the levels of the most competitive online banks. In fact, the rates are always much lower.

The fellow attempting to sell fake brokered CDs through his website – who incidentally would not provide his name by phone and was disappointed to learn that I was in my 40s and not a senior – claimed that the FDIC would have shut down his website if the rates were not real. Unfortunately, the FDIC only monitors its member institutions, and while fraudulent financial websites may fall within the SEC or the Justice Department’s purview, one need only watch CNBC’s American Greed to know that the government simply cannot stamp out financial fraud.

In fact, nobody can control what happens on the internet and a fraudster can have a pretty good year if he can just trick one person (maybe one senior) into wiring him $250,000 for a brokered CD that doesn't exist.

The best that you can do is to avoid being the one who is tricked, and purchase CDs only directly from real banks, online and in branches, having verified their rates on BestCashCow.com.

See all of the best 5 year CD rates here.

Bottom line: With certificates of deposit, too good to be true is too good to be true.