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If you like the idea of putting your money to work, then you may be interested in opening a certificate of deposit (CD). Thanks to today's outstanding CD rates , it's possible to score a 5% return on your money -- especially if you open a 12-month CD.
But while you might get the best interest rate out there with a 12-month CD, that's not necessarily the term you should choose. You may find that a longer-term CD is more beneficial financially in the long run.
The problem with 12-month CDs
A 12-month CD gives you a guaranteed return on your money for a full year. The problem, though, is that interest rates are expected to start falling pretty soon. So if you choose a 12-month CD, you might end up shorting yourself on interest.
But first, let's talk about what CDs are good for. They're generally not the best option for saving for retirement, because for far-off goals like that, you should be investing your money to score a higher return. They're also not a great place for your emergency fund because there can be costly penalties for an early CD withdrawal. So cash you might need for near-term unplanned bills should sit in a savings account .
The best use of CDs is to save for a shorter-term goal -- one that's a few years away. Investing money isn't a good idea when you don't have at least a five-year window, so CDs are a good solution when it's too risky to buy stocks but you want a better return than what a regular savings account will pay you.
But let's say you're saving for a goal that's two years out. If you limit yourself to a 12-month CD, you risk not earning a lot of interest after the one-year mark given that rates are likely to drop soon. So rather than open a 12-month CD to get the highest rate, think about your ultimate savings goal and the amount of interest you might earn over time.
Imagine you expect to have money in CDs for two years. A 12-month CD might give you a 5% APY, while a 24-month CD might only give you 4.5%.
With a $5,000 deposit, the 5% APY on a 12-month CD guarantees you $250 in interest. But after that first year, the rest is up in the air.
Meanwhile, a 4.5% APY on a 24-month CD gives you $460 in interest on that same $5,000 deposit. If you renew your 12-month CD at only a 3.5% APY a year from now, that second year, you'll get about $184. So all told, you'd only earn $434 instead of $460.
And while those two sums aren't so drastically different, if you know you expect to have money in CDs for the next two years, why wouldn't you want the larger amount of interest?
Think carefully before rushing in
You may be in a hurry to open your next CD before rates start to decline. But before you pick a 12-month CD, think about whether that's the right choice. Getting to lock in a lower interest rate on a longer-term CD might ultimately put more extra money in your pocket.
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