Investing in the stock market could be a bumpy ride. If you’re looking for something that’s a little more predictable and generate a steady interest income, investing in Certificates of Deposit might be a good option for you. This is especially true if you cannot afford to lose what you currently have, or if you are looking at a shorter investing time frame.
What are Certificates of Deposit (CDs)?
Certificates of Deposit, or CDs, 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 a CD for a specific amount of time, e.g., 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 high interest CD that yields 2.0%, it will yield 2.0% 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.
How to Build a CD Ladder Investment
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 strategy that makes CD investing more liquid and acts as a hedge against interest rate volatility. For example, let’s assume that you have $10,000 to invest. Instead of buying $10,000 in a 5-year CD at 2.5% interest, you could do the following:
- $2,000 in 1-year CD @ 2.0%
- $2,000 in 2-year CD @ 2.1%
- $2,000 in 3-year CD @ 2.25%
- $2,000 in 4-year CD @ 2.4%
- $2,000 in 5-year CD @ 2.5%
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.
A Caveat to Consider
Not all bank offers the perfect yearly interval terms. Some offers odd mix of term lengths and the interest rate also doesn’t increase uniformly. For example, many banks offer promotional rate to attract customers, and it is very possible to see a shorter term CD offers a higher interest rate.
You will have to figure out exactly what to do depending on what you bank offers
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
Pinyo is the owner of Moolanomy Personal Finance and a Realtor® licensed in Virginia and Maryland. Over the past 20 years, Pinyo has enjoyed a diverse career as an investor, entrepreneur, business executive, educator, financial literacy author, and Realtor®.