Savvy investors keep a portion of their portfolio in fixed-income investments where it’s not subject to the ups and downs of the stock market. Many people opt for the rock-solid security of certificates of deposit, or CDs, but you don’t necessarily want to go to the bank and simply buy a handful of CDs. Having a strategy can lead to bigger returns.
Interest rates rise and fall, but in a fairly slow manner. If the economy is in a slump and interest rates are in a prolonged low-rate cycle, you don’t want to get stuck buying a bunch of long-term CDs with low interest rates.
Laddering CDs can help you beat lengthy low-rate cycles because it allows you to take advantage of interest rates spread over months or years while keeping some liquidity. Laddering takes advantage of the fact that almost always, the highest interest rates are paid to the longest term CDs. In other words, a five-year CD is almost always going to have a higher rate than a one-year CD.
A CD ladder can be as long or as short as you like, but for this example let’s use a five-year ladder with five rungs. If you have $20,000 to invest, you’d invest $4,000 in each rung. You could put $4,000 in a one-year CD, $4,000 in a two-year CD and continue up to $4,000 in a five-year CD.
After a year, the one-year CD occupying the first rung matures and each of the other CDs has one less year until maturity. In other words, the two-year CD now matures in one-year; the three-year is two years from maturity, etc.
The money from the one-year CD that has just matured is rolled over into the now vacant five-year rung. Every year you’re replacing the rung that’s farthest out — in this case the five-year rung.
By always replacing the longest maturity, which is the top rung on the ladder, you’re always reaping the benefit of earning the highest interest rates. If interest rates happen to be in a slump one year, you’re only reinvesting a portion of your investment when yields are low. And you don’t have to try to guess when rates are at their highest because you’re constantly reinvesting.
The most important thing to keep in mind when laddering CDs is to make sure the maturities jibe with your cash needs. It’s no good having a one-year CD if you have an emergency halfway into the term and are in a cash crunch because your money is tied up. Penalties for early withdrawal will squash your returns. Make sure there’s enough cash in your emergency fund to carry you through until the shortest rung on your ladder matures. In other words, if the first rung is a one-year CD, you need enough cash on hand for one year of living expenses.
While a five-year ladder allows you to take advantage of the best interest rates offered, your ladder could be shorter if it makes you more comfortable. The rungs should be whatever maturities suit your cash flow needs.
In an extremely low-rate environment, it’s best to keep a ladder short. In that scenario, you could have a one-year ladder with rungs every three, six, nine and 12 months.
One caveat, it’s not a good idea to use callable CDs in a ladder. If interest rates drop, your whole ladder, or a portion of it, could be called.