CD Ladder Explained
By Pinyo • Nov 6th, 2008The recent stock market decline probably makes more than a few people realize that it’s wise to have a balance of growth and income investments as part of any portfolio. One of these income investments is Certificates of Deposit. It’s widely accessible and relatively simple in a sense that more people are familiar with CDs relative to stocks and bonds.
What Are Certificates of Deposit (CDs)?
CDs, or Certificates of Deposit, are similar to your typical savings accounts. You can purchase CDs at the same bank you have your savings account, and CDs accrue interest over time just like a savings account. The major difference is that you are committed to hold CDs for a specific amount of time, i.e., 3 months, 6 months, a year, 5 years, etc. In return, the bank guarantees the interest rate for the length of the term.
As such, CDs have some unique characteristics
- Fixed rate – If you buy a CD that yields 4.0%, it will yield 4.0% for the duration of the CD. If the rate interest goes up or down, your CD remains unaffected.
- Lack of liquidity – Since the term is fixed, you can’t cash out your CD early without incurring a penalty. This is why CDs usually pay higher yields than savings accounts and money market funds.
What Is A CD Ladder?
In general, CDs tend to pay higher interest rate on longer-term CDs. For example, a 5-year CD pays more than a 4-year CD, etc. However, it would be a bad move to plunk on your money on the longest term CD because of the illiquidity. This is where a CD ladder comes in.
A CD ladder is a mechanic that makes CD investing more liquid and acts as a hedge against interest rate volatility. For example, let’s assume that I have $10,000 to invest. Instead of buying $10,000 in a 5-year CD at 4% interest, you could do the following:
- $2,000 in 1-year CD at 3.00%
- $2,000 in 2-year CD at 3.25%
- $2,000 in 3-year CD at 3.50%
- $2,000 in 4-year CD at 3.75%
- $2,000 in 5-year CD at 4.00%
Once your 1-year CD mature, you could invest the money in a 5-year CD (to mature in year 6) to take advantage of the higher rate. And likewise, once your 2-year CD matures on the second year, you could invest the money in another 5-year CD (to mature in year 7). This means that at any given time, you are at most 1 year away from accessing 20% of your money. Here’s an illustration of what I just said:
Moreover, we can even make the ladder more liquid by incorporating high-yield savings account into your CD ladder investment strategy.
Here’s a step-by-step guide on how to start a CD Ladder by Mrs. Micah.
A CD Ladder As A Hedge Against Interest Rate Fluctuation
Beside liquidity, another key advantage of investing in a CD ladder is its ability to hedge against interest rate changes. Using the above ladder as an example, if the interest rate is low today, your shortest term CD will expire in 1 year, allowing you to take advantage of rising interest rate. However, if the interest rate is high today, you have 4 CDs that are locking in the higher interest rate for 2, 3, 4, and 5 years, respectively.
Here are a few more articles about CD Ladder:
- Build a CD Ladder at Cash Money Life
- A CD Ladder Plan For Beginning Savers at Free From Broke
- Create CD Ladders for Short Term Money Needs at My Dollar Plan
All posts by Pinyo
Got to be honest I’ve never heard of a Certificates of Deposit before, but it makes sense, especially given the ability to hedge against interest rate fluctuations
That’s a very good explanation of the CD ladder process. Thanks for sharing!
Finally, a comprehensive explanation of CDs and CD ladders! You have no idea how grateful I am. Financial dictionaries use way too many technical words in a very short sentence and it doesn’t do justice to what the CD actually is. Thanks again!
We started off slow with our CD ladder but in time it’s built up to a nice amount which makes a better interest than our standard savings! Depending on current rates we may only buy 6 or 9 month ladders (if the rates are real low) but we always continue to buy and we try to add more to each new CD when the previous one matures.
Great explanation!
@Make Friends — May be it’s call something different in your country? CDs are common in the U.S.
@BloggingBanks — Thank you.
@Aya — Wow. Thank you. It’s great to know when I did a good job.
@FFB — Thank you for sharing you story. I think CD ladder is a good way to build income. Certainly a great way for risk-adverse people to get the money working for them.
A great job of explaining CDs. I know many people do not understand the ins and outs, but this post pretty much sums it up!
Thanks for the nice illustration. I had understood the concept, but this helps clarify everything for me!
It is a good idea to keep an amount in a high-yield savings account for some liquidity. That way you do not have any penalties on the CD if you must access it because of an emergency.
Seems like a good plan, but only if you have plan to use that money in a short amount of time. If you’re saving for a house or something you don’t plan to acquire for quite a long time then putting it in the high interest fund seems much better to me.
I have an emergency fund in high yield savings for the same rate a lower CD would cost me right now - So no need for this type of scheme.
CDs keep you from taking your savings, because it kills you to pay that penalty. Nobody like paying out to a bank, but you’ll do it if you honestly need the money which is exactly how you should be doing it anyway.