Short-term vs. long-term CDs: Which is right for your savings goals?

Choosing the right CD term is important because it can affect your potential earnings and access to your money. Before you decide, it’s helpful to get familiar with the benefits and trade-offs of short-term and long-term CDs, including how they affect interest rates, flexibility, and changing market conditions. This guide can help you home in on which CD term fits your financial goals and when combining both through a CD ladder may make sense.

Key takeaways

• Short-term CDs offer quicker access to your money and more flexibility when interest rates change.
  
• Long-term CDs can provide predictable returns over several years but require a longer commitment.
  
• The best CD term depends on your financial goal, timeline, and need for liquidity, not just the highest APY.
  
• A CD ladder can help you benefit from both short- and long-term CDs.
  

Understand the difference between short-term and long-term CDs

The right CD depends on your unique goals. In some cases, a short-term CD is the better choice. Other times, however, you’d be better off with a long-term CD.

What counts as a short-term CD?

Typically, short-term CDs have terms of one year or less, offering greater liquidity with a short time commitment. A short-term CD might make sense if you want to save for a house or car you hope to buy within the next year, for example.

What counts as a long-term CD?

Long-term CDs usually come with terms of more than one year. A long-term CD can help you meet a longer-term goal, such as retirement or college savings, but it will keep your money locked up for more time than a short-term CD.

Short-term CD vs. long-term CD: Key features at a glance

Compare the pros and cons of each option

Just like all financial products, short-term and long-term CDs offer benefits and drawbacks to consider, including:

Benefits of short-term CDs

Short-term CDs are flexible. You can access your funds faster and reinvest sooner if interest rates rise. If you need money for a purchase in the next year or want to hold a portion of your emergency savings in a CD, for example, short-term CDs are worth exploring.

Benefits of long-term CDs

With long-term CDs, you can enjoy predictable returns. Depending on the rate environment, you may be able to lock in a competitive rate for several years, reducing the need to reinvest frequently. Long-term CDs are ideal if you have more time and want to grow your long-term savings.

Potential drawbacks to consider

The greatest risk of a short-term CD is reinvestment risk if rates fall before the CD matures. Also, your money might not keep pace with inflation if rates fall or inflation rises.

With a long-term CD, your money becomes locked up and less accessible for a longer period of time. Typically, you’ll owe an early withdrawal penalty if you withdraw the funds before the CD matures. In addition, inflation may erode your purchasing power if your rate is below inflation.

How short- and long-term CDs perform when rates change

Let’s say you and a friend each have $10,000 to invest in a CD. You choose a 6-month CD, and your friend opts for a 5-year CD. If rates rise, your 6-month CD offers more opportunities to reinvest at higher rates. Your friend’s 5-year CD, however, remains locked at its original rate.

If rates fall, however, your friend might be in better shape, as the 5-year CD will keep its original rate while your 6-month CD might have to be reinvested at lower rates. Your 6-month CD offers greater flexibility, while your friend’s 5-year CD provides more rate certainty.

Choose the right CD based on your financial goal

Ultimately, the ideal CD depends on your particular goals and personal preferences, rather than which one pays more. Here’s a closer look at different financial goals and the types of CDs that make the most sense for each one.

Saving for a purchase within the next year

If you want to buy a house or car within the next year, for example, a short-term CD may come in handy. It can help you earn interest on your savings while keeping your money tied up for a relatively short period of time, so it’s accessible when you’re ready to make the purchase.

Planning for medium-term financial goals

A short-term CD might be a better option for a medium-term financial goal if you know you’ll need the money within the next few years. However, if you can wait several years and are able to lock in a higher interest rate, a long-term CD makes more sense.

Locking in money for long-term savings

If your goal is to save money for the long term so you can supplement your retirement investments or send your child to college, for example, a long-term CD can fit the bill. It can allow you to secure a competitive fixed rate for several years and enjoy predictable returns.

Building an emergency fund

A short-term CD could be a good option if you know you won’t need to pull money out of it before it matures. However, since a financial emergency can pop up when you least expect it, you should keep at least a portion of your emergency fund in a liquid account, such as a high-yield savings account.

LEARN MORE: Should you keep your emergency fund in a CD?

Consider how interest rates affect your decision

Many investors make the mistake of choosing a CD based on today’s APY. However, future rate expectations also matter because they can affect whether you benefit from locking in a rate for several years or have the opportunity to reinvest at potentially higher rates when your CD matures.

When short-term CDs may make more sense

Short-term CDs are a solid choice when they offer competitive APYs, or you expect interest rates to rise. With shorter terms, you’ll have more opportunities to reinvest your money at potentially higher rates as CDs mature while enjoying greater flexibility if your savings needs change.

When locking in a long-term CD can be beneficial

You may benefit from long-term CDs when you expect rates to decline. By locking in a competitive APY, you can continue to earn that rate for the CD’s entire term, even if new CDs are available with lower rates.

Why short-term CDs sometimes pay more than long-term CDs

Long-term CD rates may be higher than short-term rates because you’re committing your money for a longer period.

“This is not always the case; occasionally short-term rates are higher due to an inverted yield curve,” said John Bliudzius, SVP and treasurer at DFCU Financial.

An inverted yield curve occurs when short-term interest rates are higher than long-term rates. This can occur when investors expect interest rates to fall in the future.

Here’s a hypothetical example:

● 6-month CD: 5.00%

● 1-year CD: 4.75%

● 5-year CD: 4.00%

Compare potential earnings with hypothetical examples

Factors like APY, term length, and how often you reinvest your money will determine how much you earn from a CD. These examples show the trade-offs without assuming rates will rise or fall in the future.

Example: Investing $10,000 in a short-term CD

Let’s say you deposit $10,000 in a six-month CD with a 4.00% APY. After six months, you’d have about $10,198, assuming no early withdrawal.

Example: Investing $10,000 in a long-term CD

Suppose you invest $10,000 in a five-year CD earning a hypothetical 4.00% APY. If you leave the money in the CD for the full term and the APY remains fixed, you’d have about $12,167 at maturity, assuming annual compounding and no withdrawals or penalties.

What happens if rates change before your CD matures?

If you open a fixed-rate CD, your APY will typically stay the same for the entire term, even if interest rates change. This can be a plus if rates fall because you’ve locked in a higher rate. However, if rates rise, you’ll be locked into the lower rate until your CD matures.

Know when to combine both with a CD ladder

With a CD ladder, you divide your money among multiple CDs with different maturity dates instead of putting all of it into a single CD. CD laddering can reduce the need to choose a single CD term.

How laddering combines flexibility and predictable returns

“By spreading money across multiple maturities, you can balance yield, liquidity, and rate risk while maintaining access to cash at regular intervals,” explained Gavin Nelson, client deposit services sales officer at Merchants Bank.

Who should consider a CD ladder instead of a single term

According to Nelson, a CD ladder is a particularly useful strategy when the yield curve is inverted and future rates are hard to predict.

Common mistakes when choosing a CD term

As you shop around and compare CD rates online, be mindful of these common mistakes.

Choosing a term based only on the highest APY

If you have to lock your money up for longer than you’re comfortable with, the CD with the highest APY isn’t the best choice. Aim to find a CD with a rate and term that works for your unique financial situation and goals.

Ignoring when you’ll actually need the money

Think about when you’ll need to access your funds and choose a CD that matches that timeline. Otherwise, you might be on the hook for an early withdrawal penalty for pulling the money out early.

Forgetting to compare early withdrawal penalties

In most cases, you’ll owe an early withdrawal penalty for withdrawing funds from your CD before the term is up. Since the penalty could significantly reduce your interest earnings, be sure to compare withdrawal penalties, especially if you think your needs may change.

Automatically renewing without reviewing current rates

Many CDs automatically renew at maturity unless you take action during the grace period. Be sure to review your situation before the renewal date to determine whether it makes sense to reinvest or move the funds to another type of account or investment vehicle.

Choose the CD term that matches your timeline, not just today’s rates

The best CD isn’t always the one with the highest APY. Rather than focusing on the rate, consider your savings goals, timeline, and the interest-rate outlook. Also, determine whether you’d be better off with a single CD or a CD ladder.

“CDs are a great tool to address different financial goals. The key is to match up the time horizon of your goals to the CD term,” added Bliudzius.

Questions savers ask before choosing a CD term

Is it better to keep renewing short-term CDs instead of opening one long-term CD?

Not necessarily. The better option depends on your financial timeline and where you think interest rates are headed. While short-term CDs offer more flexibility, long-term CDs let you lock in a competitive rate for a longer period of time.

How do I know if today’s rates are worth locking in for several years?

Consider whether the current APY is competitive and whether you are comfortable with earning it for the entire term. You can’t predict future rates, so focus on your specific savings goals instead of trying to time the market.

Can I lose money by choosing a long-term CD when interest rates rise?

Typically, if you keep the funds in your CD until maturity, you won’t lose money on your principal balance. However, you could miss out on higher returns if rates increase while your money is locked up.

Should I split my money between short-term and long-term CDs instead of choosing one?

Yes, you could divide your money between multiple short-term and long-term CDs to form a CD ladder. This strategy can allow you to balance rate opportunities with the flexibility of shorter terms.

How much does the early withdrawal penalty affect my overall return?

The impact of an early withdrawal penalty on your overall return depends on how early you withdraw the funds and the penalty itself. However, in many cases, it can significantly lower your return.

Are brokered CDs a better option for long-term savings than bank CDs?

Brokered CDs can give you access to CDs from more banks. This can help you diversify your CD portfolio, but they aren’t necessarily better for long-term savings. They can have different liquidity, fee, and early-exit considerations than CDs opened directly with a bank, so compare the terms before choosing one.

How often should I review my CD strategy if interest rates keep changing?

It’s a good idea to review your CD strategy as your CDs mature or your financial needs change. You don’t need to react to every rate change, as long as your strategy still works for your unique situation.