- A certificate of deposit (CD) is a type of savings account that offers a guaranteed rate of return in exchange for a commitment to leave your money on deposit — or in a bank account — for a certain length of time.
- Banks and credit unions offer CDs in a variety of term lengths, but most CDs have terms ranging from one month to five years.
- Short-term CDs reach their maturity in one year or less, while intermediate-term CDs reach maturity between one and four years. Long-term CDs can have term lengths of four years or more.
- Long-term CDs are less liquid than short-term CDs, since you must leave your money in the account longer. Longer term CDs may also fail to keep up with inflation, even though their rates of return are often higher.
What Is the Current State of the CD Market?
Certificates of deposit (CDs) are a type of savings account offered by banks and credit unions. When you invest your money in a CD, you’re promised a guaranteed interest rate in exchange for leaving your money locked up in the account for a specified time, known as the term length. If you decide to withdraw your investment before the CD term is finished, you’ll typically pay an early withdrawal penalty.
The interest rate you get for a new CD largely depends on the current federal funds rate, the overnight lending rate used for all banks in the U.S. As the federal funds rate increases, CD rates will usually rise. As the federal funds rate decreases, CD rates usually fall.
If all other factors are held constant, CDs with a longer term will generally offer a higher interest rate. However, this correlation between CD term length and CD rate only happens during periods of economic stability and growth. When the economy goes through periods of uncertainty and instability (as is happening now), short-term CDs may have higher rates than long-term CDs. This phenomenon is known as a yield curve inversion.
At present, we are experiencing a yield curve inversion for CD terms longer than one year. As illustrated in the graph below, the current CD yield curve inversion is comparable to the U.S. Treasury curve inversion, which is closer to being fully inverted for the terms shown.
Why Have Interest Rates Inverted?
For the most part, current CD rates have inverted due to two factors. Since early 2022, the Federal Reserve has driven up interest rates at an aggressive pace to curb inflation. Those efforts show up most dramatically at the short end of the yield curve, where the high interest rates directly influence the federal funds rate.
Additionally, investors and savers have grown increasingly concerned about the possibility of an economic recession. Due to this apprehension, some investors have pulled their money out of short-term savings accounts and moved them into long-term investments instead. The rationale is that they can lock in longer-term fixed rates now in case the Federal Reserve reverses course and begins to rapidly cut short-end rates.
Regardless of the reasoning, this movement of money puts upward pressure on shorter-term yields and downward pressure on longer-term yields.
Comparing Short-Term and Long-Term CDs
When deciding between short-term and long-term CDs, consider the length of time you’re willing (and able) to keep your money tied up in the investment.
Short-term CDs typically have maturity terms of one year or less. This type of CD is ideal if you need access to your investment in the near future or if you want to limit your exposure to rising interest rates and the risk of inflation.
Long-term CDs have terms extending four years or more. These CDs are best for investors who don’t expect interest rates to rise and don’t mind tying up their money for a long period of time. However, the relatively long term length may expose you to a greater risk of inflation.
During times of economic stability and growth, long-term CDs often come with higher yields, which can make up for the elevated levels of risk. However, as previously mentioned, the current state of the economy is causing long-term CDs to underperform when it comes to their rates of return.
Common Term Lengths and How They Differ
The most common short-term CDs have maturity periods of one month, three months, six months or 12 months. According to the Federal Deposit Insurance Corporation (FDIC), the average CD rates for these term lengths range from 0.20% all the way up to 1.72%
These average rates may not appear particularly enticing; however, it’s important to remember that they are merely national averages. We often see three to four times the national average when we look at the most competitive rates. For example, the highest-yielding short-term CDs (with term lengths of six to 12 months) are all currently above 5%.
For long-term CDs, you’ll typically see terms of four years, five years or even 10 years, but a CD term length of 10 years is very rare. According to the FDIC, the national average rates for the four-year and five-year terms are 1.30% and 1.37%, respectively. Furthermore, it is worth noting that competitive rates frequently surpass these national averages, often by three to four times the magnitude.
Intermediate-term CDs have maturities that fall between those of short-term and long-term CDs. The most common term lengths for intermediate-term CDs are 18 months, two years and three years.
Which Term Length Tends To Have a Better Rate
It’s important to consider the current economic environment when looking at CD rates and term lengths. Given the recent rise in interest rates, short-term CDs are relatively more attractive than long-term CDs. The highest-yielding CDs right now have terms that last anywhere from six months to 18 months.
Selecting a term shorter than six months results in a significant opportunity cost, as your funds could be potentially invested elsewhere. Conversely, opting for a term longer than 18 months exposes you to inflation risk without a commensurate increase in the rate of return to compensate for it. As a result, the experts at Annuity.org do not recommend investing in ultra-short CDs with terms shorter than six months or longer-term CDs over 18 months.
That said, the interest rate environment is constantly in a state of flux, and the relative attractiveness of different term lengths can change. If you need help determining the best CD term length for your financial situation, consult with a fiduciary financial advisor.
Factors To Consider When Looking at CD Terms
If a CD makes financial sense for you, the first thing to consider is term length. Generally, you should avoid longer-term CDs if you have erratic or unpredictable liquidity needs. Additionally, if you expect interest rates to rise dramatically, investing in a longer-term CD is probably not a good idea.
Beyond this basic guidance, you should always be careful with long-term investments that may not offer an adequate return on your investment. As previously mentioned, the current economic climate is such that you may want to limit your search to only the CDs with terms spanning six to 18 months.
How To Maximize Your CD Returns Regardless of the Term Length
If analyzing the CD market continuously seems daunting or if you desire to minimize the impact of sudden or substantial interest rate fluctuations, opting for a CD ladder may be the appropriate strategy.
Essentially, this strategy involves buying several equal-value CDs with staggered terms. Each term represents a step on the ladder, and each time a CD matures, you reinvest the money in a CD at the highest maturity step on the ladder.
For example, let’s assume you have $25,000 to invest. Following the CD ladder approach, you’ll put $5,000 into five different CDs. A varied range of term lengths is allocated to each of the CDs, encompassing durations of one, two, three, four and five years, respectively. Each time one of these CDs matures, you roll the proceeds into a new five-year CD. If you maintain this trend, you will attain an endless investment position, accompanied by a consistent income flow and a mitigated level of interest rate risk.