CD Ladder Explained

By Pinyo, on November 6, 2008

The 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

Read more about

Get free updates

    via Twitter
    via Facebook
    via RSS or Email

Share this article

• 
• 
• 
• 
• Share

Pinyo is the brain behind Moolanomy personal finance blog and a few other web sites. If you like this article, please subscribe for free daily email updates.

All posts by Pinyo

Please share your comment:

Comment Rules: Constructive criticism is welcomed. Please use your PERSONAL name or initials and not your business name or URL, as the latter comes off like spam and I'll most likely delete your comment. Have fun and thanks for adding to the conversation! Here's our comment policy and guidelines.

10 blogs that link to this article:

If your trackback does not show in 24 hours, please resend to this trackback URI.

1. The Friday gathering - lots of things
2. Friday Link Love - Still Recovering Edition | One Caveman's Financial Journey
3. Weekly Round-Up: Museum Edition — Green Panda Treehouse
4. squawkfox » Snow, Rain, and Slush Oh My!
5. Link Love: 12 Days and 12 Peeps to Love | I've Paid For This Twice Already...
6. What To Do With an Inheritance Money | Good Financial Cents by Jeff Rose Certified Financial Planner
7. The CD Ladder: A Different Way to Save | Prime Time Money
8. 6 Ways to Maximize Bank Deposit Returns : Bizzia - Business News and Commentary - Finance and Business Tips
9. CD Ladders - My Take | Do You Dave Ramsey?
10. Ducks and Dollars » Blog Archive » Should You Buy a Certificate of Deposit (CD)?