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.
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
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:
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.
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.