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. 🙂
- Some of the best CD rates can be found at Ally Bank. Visit their website to learn more about their different CD offerings.
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, let’s 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
- Ally Bank CDs
- Sallie Mae CDs
- EverBank CDs
Do you have a successful CD ladder? Should I start one now?