Today I will explain how to build a CD ladder (i.e. certificate of deposit ladder) to create some passive income. In short, a CD ladder is a group of CDs you might invest in that are set to expire at successive dates.
Cash from an expiring CD is used to reinvest in another CD one period older than the oldest CD currently in the ladder.
The CD Laddering Strategy Explained
Okay, here’s how you build a CD ladder. You’ll first need to determine what type of ladder you’ll want.
Does this ladder have big rungs (yearly) or many smaller rungs (monthly)?
If the maximum you can bear is without all your funds in 1 year, then a monthly ladder is right for you. If this money is just extra savings you don’t mind waiting five years on, you can do the yearly ladder.
This may be a good option for ultra-risk-averse people who don’t want to be in the turbulent stock market.
CD Laddering Example
For our example, let’s say you select yearly. It’s the quickest to set up, anyway.
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 sit back and relax, knowing your money is earning you decent, inflation-busting interest and it is 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 four years to mature) – $1,000 @ 4%
- 4-Year CD (now only three years to mature) – $1,000 @ 3.5%
- 3-Year CD (now only two years to mature) – $1,000 @ 3.0%
- 2-Year CD (now only one year 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 an excellent, high rate of return, maturing in one-year intervals. Woohoo!
Benefits 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. Your money isn’t going anywhere. You can’t touch it till the CD matures.
- CDs pay 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 your initial oldest CD becomes mature) and 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 shines when rates are dropping. While the current market offers lower rates, you still earn high interest. Rates may drop soon, so get to building your ladder.
Risks of a CD Ladder
There are some things to watch out for when building a CD ladder:
- You may be paying a hefty penalty if you withdraw money from a CD before its maturity date, leading to significantly smaller returns than initially planned.
- A rise in the interest rate during the term of your CD can cause your anticipated earnings to fall short.
- Your investments may not match the growth of inflation, leaving you with fewer funds after investing in multiple CDs for an extended period.
How to Calculate Your CD Ladder Earnings
The formula to calculate your earnings from a CD Laddering strategy is as follows:
Earnings = Sum of Interest Earned + (Principal Amount * (1 + Effective Rate) / 2)
Where Interest Earned is the interest earned on each CD and Effective Rate is the weighted average of the rates offered by all CDs combined.
The effective rate is determined by taking an average of the interest rates offered by all of the CDs combined. This can be calculated using the following formula:
Effective Rate = (CD1 ‘s Interest Rate + CD2’s Interest Rate + …+CDn ‘s Interest Rate)/n
Where n is the number of CDs in your portfolio.
What are Certificates of Deposit?
As a quick refresh, Certificates of Deposits, or CDs, are a short-term investment product most banking institutions offer.
They’re sort of like a savings account, except they are not as liquid and 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 why they can pay a higher 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 high rates and liquidity. Good things come to those who wait.
Are CDs and Laddering a Good Retirement Savings Strategy?
If you are close to retirement, likely.
Most financial advisers recommend choosing a more risk-adverse path towards retirement as an individual ages. And therefore, may not necessarily recommend bank deposits to those who are fresh out of school and beginning to enter the workforce.
However, those portfolios that have already had decades of growth under their belts, can look to protect the returns already garnered through federally insured investment vehicles which don’t expose the principal to any risk.
This isn’t too say bank CDs (even in a positive interest rate climate) should ever make up a majority of overall assets, but they should hold a generous portion of the asset section allocated to cash.
Where to Build a CD Ladder
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.
There are also “no-penalty CDs,” where you can withdraw your money early without penalty.
Which CD is correct for you can depend on many factors. The greatest of which, mentioned above, is your need for liquidity.
You can build a CD ladder at most banks that have CDs as an option. Start with your own bank and see what they have available.
Some of the best CD rates can be found at Raisin, where you can access CDs from multiple banks and credit unions under one account.
See our Raisin review to learn more about their different CD offerings.
More CD Rates
Watch Out for Early Withdrawal
But what happens if you withdraw your funds from a CD early? This is a no-no unless necessary.
You will likely have to pay the penalty and/or lose some of the interest you earned if you cash in your CD too early.
FAQs About CD Ladders
How do I choose the terms for my CD ladder?
The terms you choose for your CDs should be based on personal preference and financial situation. Generally, it is recommended to spread out the maturity dates of each CD equally over one, two, or three years.
You can also choose different maturities if your circumstances require it, such as expecting a large windfall or needing more access to funds shortly.
What type of rate should I expect when building a CD ladder?
The interest rate you receive depends largely on the length of the term of your CD, with longer-term CDs offering higher rates than short-term CDs.
However, interest rates and yields change often, so it’s best to check regularly to ensure you’re getting a competitive yield on your money.
How do I know if a CD ladder is right for me?
Building a CD ladder may be right for you if you’re looking for a safe and dependable way to save money while still earning competitive returns on your investments.
It also works well if you need access to some of your money but want the highest interest rate possible.
However, this strategy may not suit you if you’re looking for short-term investments or don’t need regular income.
Can small business owners do CD laddering?
Saving in multiple CDs with different maturity dates is an ideal option for businesses looking to keep their cashflow steady and earn higher returns on their savings.
CD Laddering allows businesses to access their savings when they need it, while still capturing better rates of return than a single CD can offer.
Do you have a successful CD ladder? Should you build one now?