Today I thought I’d share what I know about setting up a certificate of deposit ladder, or CD ladder. In short, a CD ladder is a set of CDs that you might invest in, that are set to expire at successive dates, where the cash from the expiring CD is used to reinvest in another CD one period older than the oldest CD currently in the ladder. Confused yet? Okay, let’s take a step back and discuss how CDs work. Then I’ll jump into the CD laddering strategy.
What are Certificates of Deposit?
Certificates of Deposits, or CDs, are a short term investment product offered by most banking institutions. They’re sort of like a savings account, except they are not as liquid and they pay a nicer, fixed interest rate. Liquid means how easily you can get your money out, or how “available” your money is. CDs have a designated maturity date and don’t become liquid until the period expires (matures). This is the reason they can pay a nicer interest rate than a typical savings account. You’re simply trading liquidity for higher interest. Higher interest is of course what we all want. But we each have different needs when it comes to liquidity. Some need their money next month. Others don’t need it for a couple of years. Those that don’t need it for several years will reap the benefit of a higher interest rate. But, as you’ll see with laddering you can eventually have your high rates and your liquidity. Good things come to those who wait. 
There are many options when it comes to CDs. CD maturity dates range from 1 month to 5 years. Typical offerings come in the 3 month, 6 month, 1 year, and 5 year variety. Which CD is right for you can depend on many factors. The greatest of which, mentioned above, is your need for liquidity.
But what happens if you withdraw your funds from a CD early? This is a no-no, unless absolutely necessary. You will likely have to pay a penalty and/or lose some of the interest you earned if you cash in your CD too early. This is where building a CD ladder really makes sense. You get to enjoy the benefits of higher interest earned on your savings without the major decrease in liquidity.
The CD Laddering Strategy Explained
Okay, lets set up a CD ladder. What you’ll first need to do is determine what type of ladder you’ll want. Does this ladder have big rungs (yearly) or does it have many, smaller rungs (monthly). If the maximum you can bear to be without all of your funds in 1 year, then a monthly ladder is right for you. If this money is just extra savings that you don’t mind waiting 5 years on, you can do the yearly ladder. This may be a good option for people who are ultra risk averse and don’t want to be in the turbulent stock market.
For our example, let’s say you select yearly. It’s the quickest to setup anyway. Do some research and find the highest paying 5 year, 4 year, 3 year, 2 year, and 1 year CDs. Bankrate.com has a nice list. Divide your savings into 5ths and purchase the 5 CDs with 1/5 of the money each. Your CDs will look something like this (let’s say you invest $5,000):
- 5 Year CD – $1,000 @ 4%
- 4 Year CD – $1,000 @ 3.5%
- 3 Year CD – $1,000 @ 3.0%
- 2 Year CD – $1,000 @ 2.5%
- 1 Year CD – $1,000 @ 2.0%
At this point you can just sit back and relax, knowing your money is earning you decent, inflation-busting interest and its guaranteed by the bank issuing the CDs. After one year, your accounts will look like this if you continue the ladder strategy:
- Newly purchased 5 Year CD – $1,000 @ 4%
- 5 Year CD (now only 4 years to mature) – $1,000 @ 4%
- 4 Year CD (now only 3 years to mature) – $1,000 @ 3.5%
- 3 Year CD (now only 2 years to mature) – $1,000 @ 3.0%
- 2 Year CD (now only 1 years to mature) – $1,000 @ 2.5%
- Matured (and cashed out) 1 Year CD – $1,000 @ 2.0% 0 Cash is used to purchase a new 5 year CD.
Thus, the rotation of the ladder begins. You’re expiring cash is used to purchase a new 5 year CD. Therefore, at the end of five years, and five maturity and purchase combinations, you’ll have nothing but 5 year CD rates in your ladder. Safe, secure money, paying a nice, high rate of return, maturing in one-year intervals. Woohoo!
Advantages of a CD Ladder
As you can see by how CDs work, and by the strategy, there are many reasons you’d want to have a CD ladder:
- CDs are FDIC insured up to $250,000. You’re money isn’t going anywhere. You just can’t touch it till the CD matures.
- CDs pays interest rates slightly above their online, high-yield savings account counterparts. And, as mentioned above, the longer the maturity level, the higher the rate.
- Eventually you’ll hit the sweet spot (when you’re initial oldest CD becomes mature) and you’ll start seeing long-range CD rates maturing one after another. I’ve never done this, but it’s got to feel great when you get to this point. Always a high interest rate.
- The CD ladder really shines when rates are dropping. You’re still earning high interest, while the current market is offering lower and lower rates. Currently, rates are at historic lows. So, setting this up now might not be the best idea. Still, CD rates are largely better than high-yield savings accounts, so it might still make sense for you now.
Best CD Rates
Do you have a successful CD ladder? Should I start one now?
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“Still, CD rates are largely better than high-yield savings accounts, so it might still make sense for you now.”
PT,
I went back and forth with Kevin from No Debt Plan on this issue like 9 months ago…
http://www.myjourneytomillions.com/articles/are-certificate-of-deposits-cds-worth-it/
I did the math – the interest rates were MUCH higher then, but I think the truth still stands, that the extra money made from this set up isn’t worth the loss of use of the cash involved?
Check out the math let me know what you think? But for instance,
Lets say your $5,000 is making 2% in an online savings account – you have $100 pre-tax or $80 post tax (assuming a 20% effective tax rate) for the year.
VS.
$5000 in your CD Ladder and giving you the benefit of the doubt of an effective return of 4% (just taking the higher number) you will have earned $200 pre tax for the year or $160 post tax for the year.
My point is that for an “extra” 80 bucks for the year (6 bucks a month) is it ‘worth’ to keep your money locked up?
Yes, you can access it for emergencies but almost ALL of the 80 dollar gains would be gone.
Thoughts?
I really would like to start a CD ladder for my twin daughters. We have about $3000K saved up for each of them and it is just earning the pathetic 1.5 % interest in ING. I actually logged into my account on Monday and the CD rates are equal or less than the savings account. I was shocked. What’s the point of tying up your money if the interest is less? Does this mean a rate redution for the ING savings accoung is coming?
@Lynn – that’s an excellent point. can the savings vs long-term CD rate ratio tell us about the market’s direction? or at least does it tell us what the banks are thinking?
@My Journey – there is definitely a break even point to consider. and online savings accounts haven’t helped out the CD product from a marketing perspective.
I think anyone with only $5000 to put in should stick with FDIC insured online savings. Once you get into the 50K range, when that $80 you mention becomes $800, I would think it starts becoming worth it to go with CDs.
But then again, not everyone is going to have 50K in cash savings. We should all be so lucky, right?
Great post, PT Money. I like CDs and the laddering scheme, but until things are a little more bright with the economy, I’m not going to put more money into them. I have one CD coming due soon but will just funnel it into the emergency fund for a little extra cushion. True, I could be earning more by creating a new CD ladder scheme, but I prefer the added liquidity now. Plus once rates are on the increase (and I feel content with my normal emergency fund amount), I can lock the extra money into the new, higher interest rates for CDs.
Before I bought my house in February (which has been kicking my butt, BTW), I had started a different type of ladder through ING. On every day of the month divisible by 7 (the 7th, 14th, 21st, and 28th), I was opening small 1-year CD’s. In a year, I could decide to take that money and cash out or re-up, and leads to a CD maturing every week. Then the CD rates matched the savings, so I halted. Just another strategy to consider.
Well, I think I got my answer. Its just not worth it. I actually opened up a 6 month CD at a different bank than ING at 2.25% a couple of weeks ago because I got an unexpected bonus at work and wanted to make sure I didn’t spend the money. I wanted to take 6 months to decide what to do with it (save it or pay off my husbands car). I like the strategy of the 1 year cd every week thing but that is a lot of work and my time is limited with working almost full time and having 2 year old twins!
PT lets go with the $50K in savings, if they have a 20% effective tax rate they are looking at 640 net. That is 53 bucks or so a month. I don’t think I’d tie up $50K for 1 year at a time (or I guess it would be 10K but still same argument) for an extra 50 bucks a month.
The question I guess that is more important, would you tie up that kind of liquid cash for an extra 50 bucks?
I use a CD ladder for our emergency fund. It’s just enough out of reach to keep me from temptation.
I know you guys all know that personal finance isn’t all about math…
Aren’t CD’s just a plain old waste of time? Why would I invest in a CD to expect the highest likely return of 4%. After taxes and inflation don;t I need to make about 5%-6% just to break even?
Now I guess I understand it for savings, but I still do not think I would choose that method. If I am going to save for something to be used after 5 years, I will just use a mutual fund.
Right now ING is offering 1.65% on their electric orange checking. 1.5% with a CD for one year.