Should you invest in CDs while interest rates fall? Experts weigh in

Written by ABC AUDIO on January 10, 2024

(NEW YORK) — After a high-flying performance last year, the stock market has dropped at the outset of 2024. The turnabout has sent some investors looking for alternatives, including certificates of deposit, or CDs.

A CD is a type of savings account that offers a fixed interest rate over a given period of time. If depositors remove their funds before their agreed-upon end date, however, they incur a penalty.

Investor returns for CDs have soared over the past year in response to a near-historic series of interest rate hikes at the Federal Reserve.

That trend has made this lesser-known financial instrument more attractive than it has been in years, experts told ABC News. Since the Fed expects to cut interest rates this year, they added, interested investors should move quickly before potential gains diminish.

“Now is definitely a good time to look at getting into a CD,” Cassandra Happe, an analyst at personal finance firm WalletHub, told ABC News. “Because rates are so high.”

“Investors should definitely keep a potential rate cut in mind,” Happe added, noting that some forecasters expect the Fed to slash rates within the next few months.

CDs do carry downsides, however, experts added. The fixed interest rate promised by a CD means it lacks the possibility of enormous gains, unlike a riskier instrument such as the stock market.

The best interest rate available for a one-year CD stands at 5.66%, according to a list of rates compiled by WalletHub. The shortest term length available, three months, still returns interest of up to 5.55%, WalletHub found.

Interest rate hikes at the Fed improve returns for CDs because the adjustments allow banks to charge borrowers higher costs to take out loans, Reena Aggarwal, professor of finance and director of the Georgetown Psaros Center for Financial Markets and Policy, told ABC News.

“When interest rates are high, banks can make a loan — for example, a mortgage — at a higher rate,” Aggarwal said. “So they can afford to pay their depositors more.”

When banks raise interest rates for savings accounts, such as CDs, the financial firms entice customers to deposit money with them instead of a rival, which in turn bolsters the capital a bank holds on hand to generate profits through additional loans, Aggarwal added.

“It’s all about competition,” she said.

A major benefit of CDs stems from the iron-clad certainty of their returns, Yiming Ma, a finance professor at Columbia University Business School, told ABC News.

“You’re guaranteed your money,” Ma said.

Typically, long-term CDs spanning three or five years deliver higher interest rates than short-term CDs, since a wider time horizon requires investors to part with their funds for a longer period.

However, the market currently offers higher returns for short-term CDs rather than long-term ones, in part because forecasters expect interest rates to fall steadily over the coming years, experts said. That dynamic offers investors a relatively rare opportunity to generate elevated gains without waiting a long time, they added.

“This adds to the attractiveness of a short-term CD,” Ken Tumin, a senior industry analyst for savings at online loan company LendingTree, told ABC News.

Still, he added, a long-term CD may also be an attractive option right now for investors seeking gains over an extended period, since the returns on offer for these instruments could come down significantly if the Fed cuts rates.

“A long-term CD would be beneficial if rates do fall,” Tumin said, noting that investors who took action beforehand would be locked into the elevated fixed rates for several years.

While CDs carry advantages, investors should be aware of key trade-offs, experts said.

The fixed rate of CDs promises stability but precludes the chance of stellar returns. A one-year CD delivers a return of more than 5%. By contrast, the S&P 500 — the index that most people’s 401(k)s track — climbed 24% last year. Of course, the stock market risks significant losses, as well.

Meanwhile, since CDs impose a penalty for the early withdrawal of money, they pose a problem for investors who may need to call upon the funds before a selected end date.

“CDs are good as a safe and higher-return investment for funds that you don’t need to use immediately,” said Ma, of Columbia.