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.

Why the FDIC was established

Congress, as part of the Banking Act of 1933, originally established the Federal Deposit Insurance Corporation, or FDIC. This act was passed due to the banking crisis that occurred after the stock market crash of 1929. From that time until the act went into effect 6,139 banks had ceased operations.

Since there was no system of insurance, depositors in failed banks were losing money, causing confidence in the banking system to wane. This in turn led other savers to withdraw large amounts of money from banks, contributing to even more failures.

FDIC insurance limits

The amount of account insurance, financed by premiums paid by member banks, was initially set at $2,500 per account. Due to rising levels of economic activity and changing economic circumstances that amount has been increased several times. The last time it was raised, to $250,000 per individual account, was in October 2008, in response to the financial crisis.

The FDIC’s success

This insurance program has been so successful, that to date not a single saver has lost a single dollar in an FDIC insured account, even though bank failures and mergers have taken place since the program’s inception. Even as recently as 2008, FDIC insurance, which was raised – first temporarily, then permanently - during the financial crisis, helped to stabilize the banking system.

Types of bank accounts that qualify for FDIC insurance

First, keep in mind that the FDIC only covers bank accounts such as checking, savings and Certificates of Deposit. You may purchase other products through your bank, such as mutual funds, annuities or life insurance, but FDIC coverage does not apply to them. This also pertains to other securities such as United States Treasuries, which are not FDIC insured but are guaranteed by the full faith and credit of the United States.

FDIC insurance is per individual account

The FDIC has strict rules that cover how much insurance coverage it provides per account. If the amount of money in your CD or other bank account goes beyond those limits, the excess could be at risk should the bank fail.

FDIC account ownership guidelines

To be fully insured, make sure that your deposit follows FDIC guidelines and limits. These guidelines are based on different account ownership categories, with up to $250,000 of coverage allowed for each category of account ownership you have in one bank, not by how many accounts you have in that bank.

The account ownership categories are:

Single Accounts

A single account is a deposit held in one person’s name only or held in account for one person only.

Certain Retirement Accounts

This includes Traditional IRAs, Roth IRAs, SEP-IRAs, SIMPLE IRAs and self-directed defined contribution plans

Joint Accounts

A joint account is a deposit owned by two or more people.

Revocable Trust Accounts

In general, the owner of a revocable trust account is insured up to $250,000 for each unique beneficiary.

Irrevocable Trust Accounts

Irrevocable trust accounts are held in connection with a trust in which the owner gives up all power to cancel or change the trust.

Employee Benefit Plan Accounts

These are a deposit of a pension plan, defined benefit plan or other employee benefit plan that is not self-directed.

Corporation/Partnership/Unincorporated Association Accounts

Deposits owned by corporations, partnerships, and unincorporated associations, including for-profit and not-for-profit organizations.

Government Accounts (also called Public Unit accounts)

The United States, including federal agencies

• Any state, county, municipality (or a political subdivision of any state, county, or municipality), the District of Columbia, Puerto Rico and other government possessions and territories
• An Indian tribe

For complete guidelines for each type of account, please check www.fdic.gov/deposit/deposits/insured/basics.html.

Deposits exceeding the $250,000 FDIC limit may still be eligible

You can keep up to $250,000 in an individually owned account in one bank and qualify for insurance. But if you were to have more than that amount in one bank in an individually owned account, you would not be insured above the $250,000 limit. To have FDIC insurance for the total amount, you would have to split your deposit among two or more banks.

However, for example, a husband and wife could each have an individually owned single account of up to $250,000 in one bank, so that in total they would be insured up to $500,000. Even that amount could be exceeded if it is held in a different ownership category, such as a common joint account, and again each would covered as a co-owner up to $250,000 (also to a total of $500,000).

Different account ownership at one bank

You may also exceed the $250,000 limit in one bank and still meet FDIC guidelines if you have other accounts that are in different account ownership forms, listed above, such as joint accounts or certain retirement accounts.

Rest assured that any Certificate of Deposit listed on www.BestCashCow.com is FDIC insured. Going to BestCashCow.com will help you get find the CD with the highest interest rate and the FDIC insurance coverage you need, as long as you follow the guidelines.

Credit Unions also offer Certificates of Deposit (they often call them time deposits) that are ordinarily insured by the NCUA, an organization providing similar, although not identifical coverage, to the FDIC. While all banks listed on BestCashCow.com are insured by the FDIC, please note that not all credit unions listed on BestCashCow.com are insured by the NCUA (this information can be found on the credit union's information page).

Wondering whether to open a long-term CD and get the most yield, or a short-term CD and hope that rates move up? It's a question I get asked all the time. While there is no absolute answer, there are several factors to consider that may help you make a decision.

1. Will you need the money in the next couple of years?

This is perhaps the easiest way to answer the question. If you know you will need the money in the next year, then putting it into a 5-year CD would be foolish. While you can "break" a CD, and get your money out, the penalties to do so will almost always eat up any gain from being in a longer-term investment.

2. Which term is paying more?

This may sound like a funny question. Of course the 5-year CD will pay more, but the question is how much more? A bank should pay significantly more to keep your money in a CD for 5 years than for 1 year. To see what this difference, or spread is, I looked at the difference between average 5-year and 1-year CD rates. The chart below shows that this difference, or spread, has dropped almost every week over the past six months, falling from 1.02 percentage points of diffrence in October to 0.91 percentage points last week. That's the smallest difference in over 2 years. In 2010, the spread was as high as 1.55 percentage points. Or to put it another way, in 2010, 5-year CDs paid, on average 1.55 percentage points more than than 1-year CDs while today, they only pay 0.91 percentage points more.

Why has this happened? Mainly because 5-year CDs rates have dropped faster than 1-year CD rates. The average 1-year CD rate is now 0.50%. How much further can it realistically drop and still be a viable alternative for consumers?

As an investor you'll need to decide if the spread is significant enough to warrant tying up your money for 5 years.

3. What do you think will happen with interest rates?

If you think interest rates are going to rise, then it doesn't make sense to lock money up in a 5-year CD. If you think rates are going to fall, then lock away. It would have been smart to open a 5-year CD in 2008, when some 5-year CDs paid over 5%. Rates are at record lows now. Is it wise to lock the money up and earn 1.5% APY (average 5 year CD rates) for the next five years? If rates continue to fall, it is. If rates rise, then you'll wish you hadn't locked the money away. Of course, if rates rise significantly, it may be worth it to break the CD.

By balancing these factors, you can make a more informed decision about which CD term to invest in.