You might expect that longer term CDs should pay a better APY than shorter term ones. Sometimes that’s not the case. When this happens, the banks are telling you something.
How CD Rates are Supposed to Work
It seems fair that CD rates should be better with a longer term. You’re making a greater commitment, right? In most cases, you should see higher CD rates on longer term issues (all other things being equal). Short term CD rates are higher than savings account rates because they’re less liquid, and long term CDs are even less liquid. If interest rates never changed, you’d always know that you can get a better CD rate on a longer commitment.
What happens if interest rates are expected to change? Perhaps the banks feel that interest rates in general (in the marketplace, and those set by the Fed, for example) are a bit high. If this is the case, the banks must believe that rates in general (and CD rates in particular) will be lower in the future. How do they signal this? By keeping long term CD rates relatively low.
A Surprising Trend
Consider an example. You may have a 6 month CD with a decent rate. In general, you’d expect the 12 month CD rate to be higher because of the greater time commitment – perhaps it’s another 0.3% higher. What about the 18 month CD rate? That could be maybe 0.7% higher than the 6 month CD rate. So far, so good.
In cases where banks think rates might go down, they keep CD rates relatively flat. In the example above, you might have the 12 month CD paying only 0.1% more than the 6 month CD. The 18 month CD rate (and the 2, 3, and 5 year rates for that matter) might be the same as the 12 month CD rate – or lower!
What should you do? You can buy the shorter term CD because you’re getting the same rate without locking up your cash. However, rates might go down. If that happens, you’ll be forced to buy into lower CD rates when your short term CD matures – it would have been better to lock into the longer term CD.
How to Buy in Uncertain Times
Of course, if you knew what CD rates were going to do you’d be clairvoyant. The best thing to do is use your best judgment. Depending on how much time and energy you want to spend, pick your terms accordingly. You know how long you can tie your money up, so find acceptable CD rates in that ballpark.
If you think rates will go down or stay the same, lean toward the longer terms. If you think rates will go up, lean toward shorter term CDs or money market funds. You won’t ruin yourself either way. If you’re looking at CDs for a goal that's more than a few years out, you should ask yourself whether CDs are the right choice for your money.
