A certificate of deposit (CD) is a promissory note or debt instrument issued by most banks and credit unions that entitles the bearer to receive guaranteed interest at a specified rate. It can be issued in various denominations and maturity periods, normally ranging from three months to five years. One disadvantage of a CD is that it keeps your money locked up for the maturity period, and you may be penalized if you withdraw it early.
One way to get around this problem is to buy short-term CDs of just a few months duration so you have fairly rapid access to your money if you need it. However, this usually subjects you to the lowest interest rates available. Another alternative is to create a CD ladder which will allow you to earn higher rates and spread your risk.
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What is a CD Ladder?
The concept of laddering is similar to dollar-cost averaging with stocks or mutual funds. Using that approach, instead of buying stock all at once, you stagger your purchases over a period of time. This reduces the risk that you might purchase all the shares you want at the highest recent price. If the price drops, you get more shares for a fixed amount of money. If the price increases, you buy less shares for the same amount of money. (To learn more, check out Dollar-Cost Averaging Pays.)
With CDs, the risk is not related to price as in stocks, but in the interest you could potentially earn. While long-term CDs usually pay higher rates, your money is tied up for an extended period. Laddering allows you to take advantage of higher rates while still maintaining access to a portion of your investment.
Let's say you have $5,000 that you want to invest in a five-year CD to get the highest rate possible. If you used the full amount to buy one CD, your money would be unavailable for the entire five years. Instead, you could create a ladder by buying a series of five CDs of $1,000 each. You buy a one-year CD for $1,000, a two-year CD for $1,000, a three-year CD for $1,000, a four-year CD for $1,000 and a five-year CD for $1,000. You now have your $5,000 invested in a series of CDs, one of which will mature every year. So you would have access to one-fifth of your money every year thereafter with no penalty whatsoever. Each year in this strategy represents one rung on your investment ladder.
When the first CD matures at the end of year one, that can be reinvested in a new five-year CD if you don't need your money. From then on, you would have one CD maturing every year, and this process could be repeated for as long as you want. After five years of reinvesting the expiring CDs, all would then have five-year terms and would likely be earning the highest interest rates possible. As one of those CDs expires each year, you would keep rolling the money over into a new five-year CD.
The chart below is an example of a CD ladder based on acquiring five CDs in the first year with one to five-year maturity dates. When the five-year CD is purchased in 2014 to replace the four-year CD purchased in 2010, all of the CDs will now have five-year terms. From that point forward, one of the CDs will mature each year, offering you the option of taking the cash or reinvesting it. The main advantage to this approach is the higher interest rates offered by longer-term maturities.
|1||1 year||5 year||5 year|
|2||2 year||5 year||5 year|
|3||3 year||5 year||5 year|
|4||4 year||5 year||5 year|
|5||5 year||5 year|
In times of economic uncertainty, CDs are safe investments that are insured by the FDIC up to $250,000. The downside is that they pay low interest rates and they will stay low as long as the Federal Reserve continues with its current rate policy. Purchasing multiple CDs allows you to earn a composite interest rate that will exceed the rate of the shortest-term CDs in your ladder.
By using a ladder approach, you can take advantage of higher interest rates offered on longer-term CDs while still maintaining access to a portion of your money on a regular basis. Once you buy the CD, the interest is locked in and your principal is not exposed to market fluctuations. You have the flexibility to reinvest the money or redeem the CDs upon reaching maturity. (To learn more, check out Step Up Your Income With A CD Ladder.)
The Bottom Line
By staggering your long-term CD purchases, you will be able to take advantage of higher interest rates in the future. There is a general consensus that the Fed will have to increase rates at some point to stave off inflation that would result from their current monetary policies. While it seems complicated at first, this strategy could be very useful. (Wondering where to put your money? Check out Investopedia Video for easy-to-understand explanations of stocks, mutual funds, options, futures, and much more.)
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