Are you considering a certificate of deposit (CD) to earn interest on your savings? If so, you may wonder if a short or long-term is more ideal. It depends on your unique situation and financial needs. You’ll likely find that an extended term means higher interest rates and higher earning potential. However, if liquidity is more important, a short-term CD could be ideal.
Keep reading to learn more about the differences between the two and how to choose the best option. This guide also dives into a proven strategy to build a CD ladder.
What is a Certificate of Deposit (CD), and How Does It Work?
A CD is a savings account offered by banks and credit unions. It comes with a fixed interest rate, giving you predictable earning potential.
When you open a CD, you agree to keep your money in the account for a set period, called a CD term. In return, you earn interest on your money, which you will keep once your CD reaches maturity. But if you pull all or a portion of the funds early, you’ll likely incur a penalty.
What is a CD Term?
CD terms can range from a few months to several years. As previously stated, a longer term could result in higher yields. It’s worth noting that some banks and credit unions offer promotional APYs on short-term CDs to attract more deposits.
How Long is a CD Account?
It depends on the financial institution. Short-term CDs are typically 3, 6, 9 or 12 months. You can also opt for a medium-term CD for 18 or 24 months. If you’d prefer to maximize your earning potential, long-term CDs are another option and come with 3, 5 or 10-year terms.
Short-Term vs. Long-Term CD Term: Key Differences
When choosing between short-term and long-term CDs, important factors include interest rates, flexibility, maturity terms and tax implications.
Interest Rates
Interest rates for CDs depend largely on the term. Again, long-term CDs generally offer higher rates compared to short-term CDs. This is done to reward customers who are willing to commit to saving their funds for an extended period.
Flexibility
Short-term CDs provide more liquidity, allowing you to access your money sooner. Conversely, long-term CDs lock in your money for years, limiting access.
Maturity Term
Short-term CDs usually have terms ranging from three months to a year, which is suitable for individuals who prefer quicker access to funds. Long-term CDs can extend from three to five years or more and are often selected for more long-term savings goals.
Tax Implications
Any interest accrued is taxed as ordinary income in the year it is earned, even if you don’t withdraw it. Short-term CDs might help in high-tax years as their lower interest could decrease your tax burden. Alternatively, the higher interest from long-term CDs could mean a steeper tax bill.
Other Factors You Should Consider When Choosing CD Terms
Here are some other factors to keep in mind when selecting a CD term that works best for you:
- Annual percentage yield (APY): Is the APY competitive, and will you earn the desired return on your investment?
- Early withdrawal penalty: What are the costs associated with pulling a portion or all of your funds early?
- Grace period: How much time do you have to notify the bank or credit union of your intentions once the CD matures?
What are the Pros and Cons of a Short-Term CD?
Pros
- Flexibility: Since these CDs usually require you to commit your funds for a few months to a year, your money is not tied up for long. So, it’s easier for you to plan for upcoming expenses without worrying about funds being locked away for years.
- Security: These CDs also provide security, as they often have a fixed interest rate. This means you will know exactly how much interest you will earn over the term. This can help you plan your finances with more certainty.
- Federally insured: Short-term CDs are typically insured by the Federal Deposit Insurance Corporation (FDIC) up to $250,000, adding a layer of protection for your savings. The same amount of coverage is provided to credit union CDs through the National Credit Union Administration (NCUA).
Cons
- Lower APYs: Short-term CDs often have lower interest rates compared to long-term CDs. So, while your money remains accessible sooner, you might earn less in interest.
- Less room for growth: Since you are earning interest over a shorter period, your gains won’t be as significant as with longer-term investments. If you are trying to maximize your returns, other options might be more suitable.
- Early withdrawal penalties: Withdrawing funds before the maturity date could be costly.
What are the Pros and Cons of a Long-Term CD?
Pros
- Higher APYs: Banks or credit unions favor longer commitments by offering better rates over time. So, opting for long-term CDs typically means you benefit from higher interest rates compared to short-term CDs.
- Stability: Unlike stocks or other volatile investments, the interest rate on your CD remains fixed, offering predictable returns. This makes long-term CDs an attractive option if you’re looking to grow your savings steadily without market risks.
- Secure: CDs are a low-risk way to diversify your investment portfolio. With a fixed rate, you can ensure part of your savings grows steadily while potentially diversifying elsewhere for higher risks and rewards.
Cons
- Penalties: Long-term CDs often come with penalties for early withdrawal. These penalties can reduce your earnings if you need to access your money unexpectedly.
- Less flexible: Once your money is locked in, you can’t benefit from potential increases in interest rates during the term. When rates rise, this can be a disadvantage if your CD is set at a lower rate.
- Inflation concerns: Inflation might outpace the interest on your CD. Over time, the purchasing power of your money could decline if the CD’s rate doesn’t keep up with inflation.
When Should You Choose a Short-Term CD
A short-term CD may be best if:
- You anticipate needing your funds in the near future.
- You expect rates to rise soon and want to reinvest in CDs with higher APYs.
- You prefer lower risk and more liquidity than long-term CDs offer.
- You have a short-term financial goal you want to meet.
- You want to take advantage of promotional interest rates offered by banks or credit unions.
When Should You Choose a Long-Term CD
A long-term CD could be more ideal if:
- You don’t need immediate access to your funds and can commit to a longer term.
- You want to lock in a higher interest rate for an extended period.
- You seek a stable, low-risk investment to help you meet long-term financial goals.
- You believe interest rates will drop in the future and want to secure current rates.
- You want to diversify your investment portfolio with a secure, fixed-income option.
Bridging the Gap: Building a CD Ladder
A CD ladder gives you the best of both worlds – liquidity and increased earning potential.
What is a CD Ladder?
A CD ladder is a strategy that helps you take advantage of different certificate of deposit (CD) terms and rates. By placing money in CDs with different maturities, you can access some of your funds periodically without losing potential interest from longer-term CDs. This method balances the stability of long-term investment with the accessibility of short-term savings.
How Does a CD Ladder Work?
To use a CD ladder, you divide your total savings into equal parts and invest them in CDs with varying terms. For instance, invest in CDs maturing in six months, one year, two years and so on.
As each CD matures, you can choose to reinvest in a new long-term CD or use the funds for immediate needs. This approach ensures you consistently have a CD maturing at regular intervals.
Conclusion: Short-Term vs. Long-Term CD: Which One Is Right For You?
Ultimately, you want to evaluate how soon you’ll need your money. If you might need it soon, short-term CDs are better. If you can afford to lock it away, consider long-term options.
