Question

In focus on interest rate risk, can you explain why banks offer higher interest rates on longer term CD's than they do on short term CD's?

Answer 1

The longer you get tied up with your money, the higher your rate will be. Check around, you'll find the rates are rising as the length of time increases (for example, an 18-month CD will pay more than a six-month CD). This is because the longer you commit to depositing your money, the more flexibility the bank will need to make use of your money. They are willing to pay you a better rate, because over a longer period of time they can earn more with your money. Of course in some uncertain times there are surprising exceptions to this rule.

In exchange for the customer depositing the money for an agreed term, institutions usually offer higher interest rates than they do on accounts that customers can withdraw from on demand—although in an inverted yield curve situation this may not be the case. Fixed rates are common but some institutions offer variable rate CDs with different forms. For example, interest rates were expected to rise in mid-2004—and many banks and credit unions started bidding CDs with a "bump-up" feature. These allow for a single re-adjustment of the interest rate, during the term of the CD, at a time when the consumer chooses.