Looking at interest rates for certificates of deposit (CD), you see that the five-year CD earns, say, 2% more than the one-year CD. You’d love to get that higher rate, but you’re worried about locking up your money for so long. The solution: a CD ladder, where you divide your money into several CDs with staggered term lengths. That way, some of your money will get a higher rate and some of your money is not locked up for five years. As each CD matures, you renew it for the longest term in your ladder, again snagging the highest interest rate but still have the liquidity of the next CD set to mature. Work with a financial advisor to execute this or come up with other smart money strategies to maximize your potential of reaching your financial goals.
How CD Ladders Work
When you purchase a certificate of deposit (CD), the money is held in your account until it reaches its maturity date. At the end of the term, you have access to your original investment plus the interest it earned. Typically, CDs offer a better rate than a savings account, which is the reason for parking your savings in a CD. It’s a pretty clear-cut decision. The complication is choosing the term length.
Typically, interest rates go up with term lengths, e.g., a five-year CD offers a higher rate than a one-year CD. No doubt, you want a higher rate. The problem is that it may not be smart to lock up your money for so long. You might need the money. Also, rates might rise even more while you are locked into your rate for years. This is where a CD ladder is useful.
How to Build a CD Ladder
As noted above, to build one, you buy multiple CDs with staggered maturity dates. This gives you a range of interest rates and term lengths. As each CD matures, you renew it for the longest term in order to get the highest interest rate.
For example, you buy one-year, two-year, three-year, four-year and five-year CDs, earning 1%, 1.25%, 1.5%, 2.0% and 3.5%, respectively. When the one-year CD matures, you renew it for five years at 3.5%. So now, your five CDs are earning 1.25%, 1.5%, 2.0%, 3.5% and 3.5%. After three more years (and renewals), all your CDs will be earning 3.5% (assuming interest rates stay the same), with one CD maturing every year. This can be a great investment option.
Here are the two steps necessary to build a CD ladder with an example of how it could work:
Step 1: Open Several CDs With a Ladder in Mind
You can open several different CDs, all with staggering terms. You typically want to aim for five “rungs” of your ladder with CDs having every single term length from one year to five years. With that in mind, if you had $20,000 to initially invest in your CD ladder, you could invest it like this:
- CD #1 With a 1-Year Term: $4,000
- CD #2 With a 2-Year Term: $4,000
- CD #3 With a 3-Year Term: $4,000
- CD #4 With a 4-Year Term: $4,000
- CD #5 With a 5-Year Term: $4,000
Step 2: Reinvest Each CD On Its Maturity Date
As each of your CDs hits its maturity date, you’ll get your money back plus interest. You will take all of that money (your initial investment plus all the interest you’ve earned for the life of that CD) and buy the exact same type of CD with the same maturity term. So if CD #1, from the above example, matures then you’ll reinvest $4,000 plus your earned interest into a new CD with a 1-year term.
The strategy comes with plenty of flexibility as you can break up the ladder at any point in time if the rates aren’t strong enough. You can also pocket the interest if you need the money for something and just reinvest the principal amount on the maturity date. Keep in mind that some CDs are set to automatically renew so make sure you know what action you need to take in advance.
Pros and Cons of Using a CD Ladder
A CD ladder can make an excellent investment option that provides a steady flow of savings over time. It can give you the ability to always take advantage of strong rates as they come up in the market instead of missing out on waiting for all of your money to mature in a single CD. There are also drawbacks though so let’s take a look at the pros and cons of using the CD ladder strategy.
CD Ladder Pros
A CD ladder can be a smart financial strategy that helps you hit your savings goals. Using a CD ladder to grow your savings works to your advantage, primarily, in three ways:
- Increased Liquidity: First, it offers you more liquidity (quicker access to your cash) than if you were to lock all of your money into a single CD. Once you set up a CD, you can’t withdraw any money before the maturity date without paying a penalty. With a CD ladder, the next maturity date could be right around the corner so if an emergency comes up, you can get your hands on some cash penalty-free.
- You Earn More: At the same time that you have more liquidity, you are earning higher interest rates on more and more of your money. Theoretically, by the time you have cycled through and renewed the penultimate CD, all of your CDs will be earning the highest interest rate available at the time of renewal. They’ll be doing this – without all of your money being locked up for five years or however long is the longest term in your ladder.
- Flexibility: You get to decide how and when to reinvest or what to do with your money on a more regular basis. You also have the flexibility to invest and take advantage of interest rates increasing in between terms on some of your CDs.
CD Ladder Cons
A CD ladder might not be the best investment choice for some individuals or for some situations. Here are the cons to be aware of:
- Interest Rates Can Flip: CD ladders make sense when interest rates rise in tandem with term lengths. They also make perfect sense if interest rates are holding steady. But if interest rates flip so that they are higher for shorter CDs, you wouldn’t want to be stuck on a long ladder. The same goes if interest rates are rising.
- Can Be Hard to Predict Timing: On the other hand, if interest rates are falling, you would be glad to be on a ladder where some of your money is locked in for many years. At least, that’s the glass-half-full perspective. People who see the glass half empty would think it a mistake that all of their money isn’t locked in.
- Best Used as a Hedge: CD ladders are best used as a hedge. They may or may not maximize your earnings. But they will keep some of your money liquid.
Shop Around for the Best Rates
If you’re set on laddering CDs, checking out what different banks are offering is a must, just as you would with a mortgage loan or a high-yield savings account. Online banks in particular tend to offer higher rates because they generally have lower overhead costs than brick-and-mortar banks. When building your CD ladder, remember that CDs have relatively low rates of return and manage your expectations accordingly. You can also just have your financial advisor complete this process for you.
The Bottom Line
A CD ladder can provide you the flexibility to invest more of your money as the market changes, or hold for the right time. You also get to continually take advantage of strong rates and maximize your potential savings return. It’s not always easy to manage, though, so it’s important to have experience or work with an expert who does.
Tips for Investing
- If you prefer the human touch and talking face-to-face when working with experts, consider working with a traditional financial advisor. Finding a financial advisor doesn’t have to be hard. SmartAssset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- If you don’t have a lot to invest, consider signing up a robo-advisor. Generally, these automated investing platforms offer lower fees and require smaller account minimums than traditional financial advisors.
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