CD Rates Could Rise This Year -- But Be Careful Not to Make This Mistake

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KEY POINTS

  • Interest rate hikes by the Federal Reserve are benefiting consumers in the form of higher savings account and CD rates.
  • If you're going to open a CD, you may only want to tie up your money for a limited period of time.

It's an error that could cost you money.

A few weeks ago, I encountered a pleasant surprise when I logged onto my savings account to check my balance. I saw that the interest rate on my savings has risen, and that my bank was starting to pay more money on certificates of deposit (CDs), too.

Since I had extra money in my savings account, I decided to transfer some of it into a CD. But I made sure to limit myself to a one-year CD. And if you're interested in opening a CD, you may want to stick to a similar plan.

CD rates are on the rise

Soaring inflation has clearly gotten the Federal Reserve's attention. In an effort to slow its pace, the Fed has been implementing aggressive interest rate hikes that are making borrowing more expensive. The logic is that if it costs more to finance a purchase via a loan or credit card, consumer spending will start to decline. Once that happens, it should narrow the gap between supply and demand that led to rampant inflation in the first place.

Of course, higher borrowing rates are bad news for consumers. But it's not just borrowing rates that are climbing as a result of the Fed's interest rate policies. Savings account and CD rates are also increasing. And since the Fed may not be done with its rate hikes, it's fair to assume that CD rates could rise this year even more. That's a situation you may want to take advantage of -- but only to a point.

Don't lock your money away for too long

Right now is probably a good time to open a one-year CD. In doing so, you might snag a much higher interest rate on your money than what a savings account will pay you.

But one thing you may not want to do is lock your money away in a longer-term CD, like a five-year CD. We don't know what rate hikes the Fed has in store, and how they might impact CDs. But five years is a long period of time to tie your money up, and interest rates could rise a lot in the course of half a decade. If you open a five-year CD, you could end up losing out on the opportunity to score a higher interest rate on your cash down the line.

What’s more, the difference in interest rates between a one-year CD and a five-year CD may not be all that substantial right now. So before you agree to tie your money up for five years, compare your rate options. You may find that a five-year CD isn't even worth contemplating given the limited upside compared to a one-year CD.

Of course, cashing out a CD early is always possible, so if you open a five-year CD and interest rates rise a lot, you could technically take your money out and open a new CD. But in doing so, you'll lose several months of interest as a penalty (the exact amount will depend on your bank). So what you gain by switching to a CD with a higher interest rate, you might lose in penalty form.

All told, there's nothing wrong with opening a shorter-term CD right now and benefiting from a higher interest rate on your money. But I wouldn't suggest opening a longer-term CD given that more interest rate hikes are still on the table.

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