- The prime rate is the interest rate that lending institutions charge on loans to customers with excellent credit ratings. Though individual lending institutions set their specific prime rate, it is typically 3 percent more than the federal funds rate. The federal funds rate is the interest rate banks and other lending institutions charge one another for overnight loans. A division of the Federal Reserve, called the Federal Open Market Committee (FOMC), changes the federal funds rate in response to current economic conditions.
- When you buy a fixed interest rate CD, the interest on it does not change for the specified term of the CD. This means that even if the prime rate decreases during the time you own it, the interest you earn on the CD does not decrease. If the prime rate decreases by the time your CD reaches maturity and you choose to renew it rather than cash it out, your renewed CD will earn the lower interest rate and not the higher, original interest.
- When you buy a variable interest rate CD, the interest you earn changes with the movement of the prime rate. If the prime rate decreases, the interest your CD earns decreases. If the prime rate increases, the interest your CD earns increases. It is important to note that lending institutions tie CD interest rates to different markets and indices. Movements in the prime rate only affect CDs tied to this rate.
- The principal amount is the amount of money you pay when you purchase a CD. The Federal Deposit Insurance Corporation (FDIC) insures your principal investment amount up to $250,000 for both fixed and variable CDs. This insurance, of course, does not apply to returns. What this means is that if you invest in a $10,000 CD, you will not lose your initial $10,000 investment, because the amount falls under the FDIC insurance limits.