You’ll find plenty of CDs touting rates above 5% — but here’s a ‘very real risk’ you should consider. -- MarketWatch

Press Release from Financial Wellness Strategies

Feb. 8, 2024 

By Alisa Wolfson

What type of certificate of deposit might be right for you now?

Plenty of CDs are touting payouts above 5%, and in general now, short-term CDs tend to pay a somewhat higher annual percentage yield (APY) than long-term CDs. But that doesn’t mean a short-term CD is always the best bet.

“Even though yields on longer term CDs are lower than shorter-term CDs, the return is locked in. With a shorter-term CD, you have the very real risk that upon maturity when you go to reinvest, you will do so at lower yields that you can get today,” says Greg McBride, senior financial analyst at Bankrate. “The reason longer-term yields on Treasurys and CDs are lower than shorter maturities is on the expectation of lower interest rates to come.” By long-term CDs, we’re referencing anything with maturity dates beyond one year.

Various experts and surveys have predicted a drop in interest rates this calendar year, with many anticipating the first cut coming mid-year. A recent Reuters poll of economists revealed that the Federal Reserve will wait until the second quarter before cutting interest rates. Jerome Powell, chair of the central banks, said the Fed recognizes that keeping rates high for too long could endanger the economy. Indeed, the Fed itself has projected three interest rate cuts this year, with the first happening as soon as March.

While it might seem counterintuitive to lock your money up longer for less, if you believe rates will go down, locking in a strong rate on the longer-term CD locks you in for a longer time, says Bobbi Rebell, founder of Financial Wellness Strategies.

For the average consumer, the yield difference in short- and long-term CDs won’t have a significant impact on the interest earned, according to Daniel Carey, head of finance and accounting at Cambridge Savings Bank. “A 25 basis point difference in a rate on a $1,000 deposit equates to $2.50 on an annual basis,” says Carey. 

In the last 20 years, there have been long stretches of very low interest rates. “Opening long-term CDs before these long stretches of low rates has proven to be worthwhile. Even though today’s long-term CD rates are generally lower than short-term CD rates, they are likely higher than what short-term CD rates will be a year from now,” says Ken Tumin, senior industry analyst at LendingTree.

For his part, Tumin says the reason to choose long-term CDs is to boost your long-term rate of return. “Over a multiple year period, long-term CDs will have a higher average rate than that of short-term CDs. Thus, it makes sense to include at least some long-term CDs in your portfolio,” says Tumin.

Of course, not everyone should opt for a CD. If you can’t tie up your money, these vehicles probably aren’t for you.

The smartest approach, says certified financial planner Aaron Lieberman at Marathon Wealth Management, may be to invest in both short-term and long-term CDs if CDs are a fit for you.  “If you believe rates are going down, you could invest in both short- and long-term, or you could set up a CD ladder where investments mature at different times,” Lieberman says.

If liquidity isn’t an issue, Lionel Poudevigne, senior vice president at KeyBank, says, “Like any rate decision, it’s a function of what you believe rates are going to do over time. If you believe the long-term CD rates offered today are high compared to where you see rates going over time, then locking in that rate may be a good option.” 

Much of money management is psychology, which is why many investors choose to outsource the management of their portfolio, says Lauren Lindsay, a certified financial planner (CFP) at Beacon Financial Planning.  “If someone is happy enough with the rate and the certainty of that return over time is the most important thing to them, that could be a reason [to opt for a lower long-term rate],” Lindsay says.

Ultimately, chasing the highest rates on savings vehicles isn’t always the smartest decision, says Lieberman. “Online savings accounts are now paying very competitive rates; however, you must look into your tax rates to determine if taxable income or tax free income makes more sense,” Lieberman says. “Also, there are many Treasury MM Funds that are paying around 5% and are completely liquid. Depending on the state, you might not have to pay state income taxes on the Treasury income.”

What’s more, chasing the highest rates without considering other factors like the stability of the financial institution and the overall portfolio risk might expose an investor to undesirable outcomes, says Marcel Miu, a CFP at Simplify Wealth Planning. “It’s important to consider the whole financial picture, including risks and investment goals, rather than focusing solely on the rate,” Miu says.