Long Term CDs vs Short Term CDs

Should I invest in a long term CD with a better rate or a short term CD at a lower rate and hope rates increase in the short term?

You may be surprised to find that long-term CDs can be much better deals than short-term CDs even if you think interest rates will rise substantially in the next year or two. If interest rates stay low, the long-term CDs are better since the interest rates are much higher than short-term CDs. If interest rates rise substantially, you can close the long-term CD early. You'll be hit with an early withdrawal penalty, but for many banks and credit unions, the early withdrawal penalty is mild. With a mild early withdrawal penalty, the long-term CD closed early can return more than short-term CDs that you hold to maturity. It can also be better than just keeping your money in a savings account.

Two institutions which have competitive long-term CD rates and mild early withdrawal penalties are Ally Bank and Pentagon Federal Credit Union.

There are two risks with this long-term CD strategy:

  1. The bank refuses to allow an early withdrawal
  2. The bank increases the early withdrawal penalty on your existing CD

What is a Certificate of Deposit (CD) Ladder?

certificate of deposit ladder is an investment strategy used to invest in certificates of deposit when interest rates are rising. Interest rates and CD rates usually rise when the economy is expanding and the Federal Reserve is raising rates to keep inflation in check.

Locking into longer term certificates of deposit when CD rates are rising may prevent you from taking advantage of an increase in CD rates. One way around this is investing in a certificate of deposit ladder. The strategy used in a CD ladder is to evenly spread out your deposits over a period of several years. In the end all your money is deposited in longer term certificates of deposit which pay a higher CD rate.

Let’s look at an example certificate of deposit ladder. We will use a three year CD ladder with $30,000 for this example. You invest $10,000 in a 3 year CD, $10,000 in a 2 year CD and $10,000 in a 1 year CD. After year one, the 1 year $10,000 CD matures, the CD investor then invests the money in a 3 year CD.

After year two, the 2 year $10,000 CD matures, the CD investor invests in another 3 year CD. After two years all the money is invested in 3 year CDs at a higher interest rate. In a raising rate environment, this allows you to get increasingly higher CD rates.

In a falling rate environment it makes more sense to lock in your money at the highest CD rate possible.