I was at the gym yesterday and a friend who manages money for wealthy New Yorkers asked me if his clients (a married couple) should be putting $500,000 into a 1-year CD here and now at 2.00%.

He believes that with the stock market at an extremely elevated valuation and likely to correct, with the 10-year bond at 1.60% and yields likely to rise, and with little opportunity for appreciation in gold and other alternative assets, a one-year CD seems like a good place to hide out.

I quickly explained that 2.00% is not the highest one-year CD rate. You will find higher rates online here (hyperlink), and you may find still higher rates at banks and credit unions where you live.

Then, I turned to the cash versus CD discussion.

For some time, I have recommended one-year CDs as a way to improve your return on cash that you want to keep liquid but know that you will not need for over a year. As the Fed was increasing rates and the expectations was for further increases, the spread between CDs and savings was also increasing. This time last year, the best online savings rates stood around 2.30% and one-year online CDs were around 2.85%.

While BestCashCow’s surveys still reflect a wide spreads nationally (see the chart on the top of our online one-year CD page), the highest online savings rates are not much below the best one-year CD rates today.

Savings is always going to give you more flexibility. It can be accessed without penalty in an emergency. It can be deployed instantly should you see a market opportunity or some sort of other opportunity. So, I think that there is a strong argument for holding cash in savings or No Penalty CDs here and not now buying new short-term CDs (or allowing short-term CDs to auto-renew).

At the same time, I’ve always argued that there is very little risk in a one-year CD. You are never very far from maturity, and the standard early withdrawal penalty on one-year CDs is only three months’ interest (but, you should always check on the early withdrawal rules and fees before buying a CD). And, while it is hard to get excited about the narrowing margin, there is a real risk as we work through 2020 that President Pence will try to raise money from real estate developers and try to force Fed Chairman Jerome Powell to continue to lower the Fed Funds rate to zero (as Trump did).

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.