A Certificate of Deposit or CD allows you to deposit money for a fixed period of time in return for a higher interest rate than you’ll get from a regular savings account. A CD ladder allows you to gain that higher interest rate without the risk of having too much money locked up and inaccessible.
Why Do People Use CD Ladders?
CDs come in term lengths of three months to five years. It makes sense to buy CDs at different maturities so you can periodically unlock your money and reinvest at a higher rate or use it for expenses and purchases. Some people use CD ladders to save for college or other expenses that come at predictable times.
Tip: The longer the maturity, the higher the interest you earn.
Higher Interest Earnings
You can get high interest in a five-year CD, but you may be able to make more with a CD ladder if interest rates rise. If you have some shorter-term CDs in a ladder and they mature, you can reinvest at a new higher rate when you get your money back. You will earn more income if you keep investing at higher rates when your three-month, six-month, one-year, and two-year CDs mature.
Here is an example from a free online calculator. If you invest $50,000 in a five-year CD at current rates and leave it for ten years (renewing it when it matures), you would have an ending balance of $68,873. Creating a ladder would give you an ending balance of $69,902. You would earn more than $1,000 extra.
|Amount Invested||End Balance With 5-year CD||End Balance With CD Ladder|
Interest rates will vary, so these are rough figures. The standard ladder that the calculator used for these projections may be structured differently than yours.
Protecting Against Falling Interest Rates
If interest rates begin to fall, you will have locked in higher interest for the term of each CD. As your CDs mature, you don’t have to invest in the lower-rate CDs coming on the market. You can invest your money elsewhere.
Waiting on the Stock Market
When the stock market is volatile and uncertain, a CD ladder will let you earn interest while you wait to see which direction the market will go. You don’t have to gamble and plunge into stocks during uncertain times. A CD ladder will pay you while periodically freeing up money if you want to invest in stocks.
Different Ways to Structure a CD Ladder for Various Purposes
There are many ways to build a CD ladder. Your choice will be based on your financial goals and how long you plan to invest your money.
A Typical Example of how to Configure a CD Ladder
Assume you choose to build a CD ladder with five maturities and that you have $2,000 to invest. Divide the funds into five CDs with different maturity dates.
- $400 into a three-month CD at 2.00 percent
- $400 into a six-month CD at 2.25 percent
- $400 into a one-year CD at 2.50 percent
- $400 into a 15-month CD at 3.00 percent
- $400 into a two-year CD at 3.25 percent
When the first CD matures, you can get your cash out and continue building your ladder by reinvesting. Every time you climb past a rung at the bottom of your ladder, you can add another to the top.
You will also have access to cash at regular intervals without sacrificing your interest gains.
Continue the process as long as you want to maintain the CD Ladder.
If rates continue to increase, you will earn more as you move your balances from these initial CDs into new CDs. You can decide to use the same bank or search elsewhere for the best CD rate.
How to Change the Ladder Structure According to Your Goals.
CD ladders can be organized in different ways to meet different goals.
- If you anticipate needing your money in a year or so, focus your ladder on short-term maturities.
- If you want the best rate and won’t need your money for five years or more, make the lower rungs of your ladder one to five-year CDs.
- If interest rates start falling or if you expect interest rates to fall, invest in long-term CDs, with the lowest rung being two years and the highest being five. You will lock in high rates.
- If you think interest rates may rise for a long time, consider opening five CDs with one-year, two-year, three-year, four-year, and five-year terms. Once each CD matures, roll the balance into a higher-interest five-year CD.
Tip: You do not have to reinvest proceeds into CDs of the same maturity. It is your money, and you can change your CD ladder strategy as you see fit.
Pros of CD Ladders
These are some of the advantages you get from a CD ladder.
- Higher Interest Rates – CDs pay significantly higher interest rates than savings accounts. Banks pay CD investors a higher return in exchange for locking their money for a fixed term. This is true for every rung on your ladder.
- Freedom of Selection Based on Terms and Account Options – CDs are available in various maturities and at different interest rates from thousands of banks and credit unions.
- Some banks offer CDs without penalties for early withdrawal.
- A few banks may offer a 10-year CD.
- Other CDs you might encounter include step-up and bump-up CDs. These CDs increase the interest you earn over time. For example, a step-up CD might start with a two percent interest rate and increase by one percent every year.
- You can find Jumbo CDs. Typically, these require a minimum deposit of $100,000 and pay a higher interest rate than regular CDs. If you have the resources you could make a CD ladder out of Jumbo CDs.
This range of options will help you select the CD ladder that best serves your needs.
- Safety – The CDs of federally insured banks and credit unions are backed by the credit of the United States government up to a maximum of $250,000 per depositor, per insured bank. Even if a financial institution is forced out of business, your money is safe up to the guaranteed limit. Your entire CD ladder is covered.
Cons of CD Ladders
Like all investment instruments, CDs also have disadvantages.
- Inflation Risk – Investing in CDs carries the risk that your money will lose its purchasing power over time because your interest earnings will be reduced by inflation.
- Reinvestment Risk – It is possible that when the CD matures, yields will have fallen, and if you choose to reinvest, it will be at a lower interest rate.
- Early Withdrawal Penalties – If you withdraw early on any CD in your ladder, expect to lose approximately three months of interest on a one-year CD, six months on a two-year CD, and so on. The penalty depends on the length of maturity for the CD. At some banks, the penalty might be any interest earned, no matter the maturity date.
Tip: You are not prohibited from withdrawing money from a Certificate of Deposit early. You can get your cash back at any time. You just pay the penalty.
CDs are designed to hold money you do not plan to spend immediately.
- Accessibility – Savings and money market accounts can include debit or ATM cards. Certificates of deposit do not offer this convenience.
- Tax burden – You will have to pay taxes on the accrued interest when each CD matures.
Tip: You can create a CD ladder in your retirement account. If you have a regular IRA, you won’t pay tax on your interest earnings until you withdraw the money from your IRA.