How to Decide Whether to Open a Shorter or Longer Term CD

Wondering whether to open a long-term CD and get the most yield, or a short-term CD and hope that rates move up? It's a question I get asked all the time. While there is no absolute answer, there are several factors to consider that may help you make a decision.

1. Will you need the money in the next couple of years?

This is perhaps the easiest way to answer the question. If you know you will need the money in the next year, then putting it into a 5-year CD would be foolish. While you can "break" a CD, and get your money out, the penalties to do so will almost always eat up any gain from being in a longer-term investment.

2. Which term is paying more?

This may sound like a funny question. Of course the 5-year CD will pay more, but the question is how much more? A bank should pay significantly more to keep your money in a CD for 5 years than for 1 year. To see what this difference, or spread is, I looked at the difference between average 5-year and 1-year CD rates. The chart below shows that this difference, or spread, has dropped almost every week over the past six months, falling from 1.02 percentage points of diffrence in October to 0.91 percentage points last week. That's the smallest difference in over 2 years. In 2010, the spread was as high as 1.55 percentage points. Or to put it another way, in 2010, 5-year CDs paid, on average 1.55 percentage points more than than 1-year CDs while today, they only pay 0.91 percentage points more.

Why has this happened? Mainly because 5-year CDs rates have dropped faster than 1-year CD rates. The average 1-year CD rate is now 0.50%. How much further can it realistically drop and still be a viable alternative for consumers?

As an investor you'll need to decide if the spread is significant enough to warrant tying up your money for 5 years.

3. What do you think will happen with interest rates?

If you think interest rates are going to rise, then it doesn't make sense to lock money up in a 5-year CD. If you think rates are going to fall, then lock away. It would have been smart to open a 5-year CD in 2008, when some 5-year CDs paid over 5%. Rates are at record lows now. Is it wise to lock the money up and earn 1.5% APY (average 5 year CD rates) for the next five years? If rates continue to fall, it is. If rates rise, then you'll wish you hadn't locked the money away. Of course, if rates rise significantly, it may be worth it to break the CD.

By balancing these factors, you can make a more informed decision about which CD term to invest in.