What is a CD ladder?

Posted on Wednesday, May 22nd, 2019 MarketBeat Staff

Summary - A CD ladder is a strategy in which multiple certificates of deposit (CDs) are purchased at varying, and progressively longer, maturity dates. As the first (shortest) CD expires, the investor can choose to reinvest the principal and interest into a new long-term CD. In this way, investors will have a constant cycle of expiring CDs, which can be important for having funds available for short-term or emergency cash flow needs. If the cash is not needed at the time, laddering allows investors to take advantage of the higher interest rates provided by longer-term CDs.

For example, an investor who is looking to invest $30,000 in a five-year CD ladder will purchase five individual $6,000 CDs. The first CD will have a maturity of one year; the second CD will have a maturity of two years; the third will have a maturity of three years... until the final CD matures after five years. As each certificate matures investors can reinvest the CD into a new five-year CD so that, after the initial five years, the investor will continue to have a CD that matures every year while allowing them to take advantage of the higher interest yields that longer-term CDs provide. 

The maturity dates of CD ladders can be set depending on an investor’s individual financial circumstances. For example, a retiree may choose to have a CD ladder with quarterly or semi-annual maturities to cover anticipated expenses. An investor who may be using a CD ladder as a college fund may choose to have ladders of five years or more.

Introduction

In a typical portfolio, investors will want to set aside a certain amount of money as cash. A certificate of deposit (CD) can be an attractive product because it ensures owners the return of their principal, in addition to the interest that they earn on the CD which is higher than investors can get from a traditional deposit account or money market account. The tradeoff is that investors will not have access to their cash (without penalty) until the term of the CD expires. In addition to the risk of having their cash tied up, investors face the risk of missing out on a higher interest rate while their money is tied up in the CD. An appealing option is for investors to divide their CD investment into a CD ladder – which is simply multiple CDs that have varying, longer maturity rates. In this way, investors will have access to cash at regular intervals, if needed. And if they don’t need the money, they can reinvest the maturing CDs into a new certificate with a maturity date that can take advantage of more favorable interest rates. This article will breakdown the strategy of a CD ladder, and illustrate how they can help investors manage the risks that come from the cash side of their portfolio.

What is a CD ladder?

A CD ladder is an investment strategy in which a fixed amount of money is divided equally among multiple certificates of deposit purchased at varying maturity dates. The purpose of a CD ladder is to allow investors to manage both interest rate and liquidity risk. Before going into more detail about a CD ladder, it’s important to understand what a certificate of deposit is and the role it can play in an investor’s portfolio.

What is a Certificate of Deposit?

A certificate of deposit is a financial product that allows a financial institution (such as a bank or credit union) or brokerage firm to hold a depositor’s funds until a fixed maturity date in exchange for a fixed rate of return. Because the principal within a CD is FDIC insured, a CD is considered to be a virtually risk-free investment.

Although in some cases, a depositor can cash out their CD before its maturity date (with a penalty), the implied tradeoff is that the owner of the CD is taking a liquidity risk (i.e. not having access to their money) for the guaranteed of a higher interest rate than they can get through another savings vehicle such as a savings account or money market account.

All interest rates advertised for a CD are based on an annual percentage yield. So a CD paying 3% would mean that an investor who puts $1,000 into a one-year CD would receive $1,000 plus the 3% interest at the end of the first year. Since the interest earned on a certificate of deposit is compound interest, the value of the CD at maturity would depend on how frequently the interest was compounded. Most CDs will compound interest daily or monthly.  This can make a significant difference in the value of the CD at maturity.

What happens when a CD reaches maturity?

At maturity, investors have two options. The first option is to simply cash out the CD, usually into their existing checking or savings account if the CD is purchased through a bank. The second option is to re-invest the CD into another CD. This allows investors to continue to take advantage of compound interest. It's also a way to hedge against fluctuating interest rates. CD ladders are a common technique used when re-investing CDs.

CD ladder example

As previously stated, to create a CD ladder a buyer will purchase multiple CDs at varying maturities. For example, an investor could choose to invest a total of $20,000 evenly into CDs at one-year intervals between one and four years. As each certificate expires, the investor will re-invest the CD into a fixed-rate 4-year CD. In this way, every year they will have a CD expiring, but they will have access to at least $5,000 (+ accrued interest) annually. This chart (without interest numbers) helps illustrate a CD laddering strategy.

Buy Today

End of Y1

End of Y2

End of Y3

End of Y4

End of Y5

1-year CD @ 2.5%

$5,000

$5,000 (+2.5% compounded)
Purchase 4-year CD @ 3%

Interest is compounding

                                                                                                                       

This CD is ready to be re-invested or redeemed

2-year CD @ 2.6%

Interest is compounding

$5,000 (+2.6% compounded)
Purchase 4-year CD @ 3%

Interest is compounding

3-year CD @ 2.7%

Interest is compounding

$5,000 (+2.7% compounded) Purchase 4-year CD @ 3%

Interest is compounding

 

 

4-year CD @ 2.85%

Interest is compounding

$5,000 (+2.85% compounded) Purchase 4-year CD @ 3%

Interest is compounding

 

There are a variety of self-help tools, such as CD laddering calculators available on the internet. Interactive tools, such as a CD ladder calculator can help investors decide the optimum balance of maturity dates and annual percentage yields that will meet their objective. Investors can also look at their financial planner for investment advice.

How do CD ladders protect against rising interest rates?

One of the benefits of a certificate of deposit is that the interest rate is locked in. In our example above, if an investor purchases a four-year CD with an interest rate of 3.0 percent, the interest rate will remain at 3.0 percent no matter what decision the Federal Reserve makes on the benchmark Federal funds rate throughout the period of time they own the CD. So even if the economy has a downturn and the Fed lowers interest rates in an effort to stimulate the economy, an investor is guaranteed the interest rate that was in place when they bought the CD. In exchange for the guarantee of receiving a higher interest rate, investors agree to keep their money in the certificate of deposit until its maturity date (in some cases, an investor may withdraw the CD but will have to pay a penalty which will eliminate any interest benefit and also will mean they do not receive the full amount of principal invested).

However, while a CD offers great insurance against falling interest rates, rising interest rates create a risk for CD owners. For example, what if during the first year of owning a four-year CD, the interest rate of a four-year CD climbs from 3.0 to 3.25? The investor is locked into their current CD and they would miss out on the gain from the higher rate. By executing a CD ladder strategy, an investor can reinvest a maturing CD and lock in the new, higher interest rate.

How to choose a maturity period for a CD ladder?

Most CDs offer maturity periods as short as three months and as long as five years. When considering what length is right for their laddered portfolio, an investor must consider their personal financial situation. For example, if they are self-employed or work in an industry that has high turnover, they may want to consider shorter maturity dates that will allow them to have access to their funds – without penalty – at more frequent intervals. Also, if an investor feels that interest rates are likely to rise in the near future, they may choose a shorter term so that they can more easily move their money to a product with a higher interest rate. Using shorter maturity periods can also be an effective strategy for funding an emergency fund with three to six months of living expenses. CD ladders can be set to expire on a quarterly basis with the maturing CD either being reinvested into other CDs or cashed out and placed into a high-yield savings account.

For some younger investors, a good strategy is to start with short-term CD ladders and, as their cash account increases, begin to set aside some of the money in longer ladders while still maintaining approximately three to six months of emergency cash in short-term ladders.

How to choose where to buy a certificate of deposit?

Once an investor decides they want to engage in a savings strategy such as a CD ladder, they will find there is no shortage of options for finding where to buy them. Even in this era of low-interest rates, CD rates are advertised prominently by any bank or credit union. However, online banks have become viable banking sources. These banks do not have the physical costs of a brick-and-mortar bank and therefore can frequently offer higher yields. These online banks, such as EverBank, can offer highly competitive interest rates and may even offer a wider variety of products such as step-up CDs, bump-up CDs, or IRA CDs. Most CDs require a minimum deposit that increases along with the yield. And as stated before, although the funds in a CD are FDIC insured, they come with early withdrawal penalties.

Understanding the different kinds of certificates of deposit

  • Liquid CDs– Liquid CDs carry low, or in some cases no, early withdrawal penalties. However, the trade-off is the interest rates are lower and they usually require a larger minimum balance requirement than other fixed-rate CDs.
  • Bump-Up CDs– These are liquid CDs, that give owners an option to switch (or bump up) to a CD with a higher yield. There is usually a limit to how many times an investor can bump up to a higher rate.
  • Step-Up CDs–Step-up CDs are like bump-up CDs except in the case of a step-up CD, the interest rate is automatically raised on a preset basis. This blended interest rate may be attractive at times when interest rates are expected to decline.
  • IRA CD– These are fixed-rate CDs that are held inside an individual retirement account (IRA).
  • Brokered CD– this is a CD that is sold through a brokerage account. Although these CDs may offer a higher interest rate, brokered CDs may not be FDIC insured. These CDs can also be more difficult to get out of at maturity.

The bottom line on CD ladders

CD ladders can be an effective strategy for investors who want to take advantage of higher interest rates for money that they can afford to have locked in for a specific period of time. Each rung of a CD ladder represents an individual CD. The lowest rung of the ladder have the shortest maturity dates and the higher rungs have a longer term to maturity. As the short-term CDs come to maturity, if the money is not needed, investors may choose to reinvest the money into a long-term CD that is set to expire after the longest term, in this way they will always be able to take advantage of the higher rates that typical of long-term CDs while still having liquidity by having CDs that are expiring on a regular basis.

CD ladders can be a hedge for investors who are concerned about locking up a substantial amount of money in a long-term CD in an environment where higher interest rates are likely. Although forecasting the future direction of interest rates is always an imperfect science, the use of CD ladders can offer investors a good option for maximizing their yield regardless of the direction interest rates move.

 

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