DEFINITION of 'CD Ladder'

A CD ladder is a strategy in which an investor divides the amount of money to be invested into equal amounts in certificates of deposit (CDs) with different maturity dates. This strategy decreases both interest rate and re-investment risks.

BREAKING DOWN 'CD Ladder'

A Certificate of Deposit (CD) is an investment product that offers a fixed interest rate for a specified period of time. The invested funds, which are insured up to $250,000 by the Federal Deposit Insurance Corporation (FDIC), are locked in by the issuing bank until the maturity date of the CD. Maturity dates for these savings instruments are typically set at three months, six months, one year, or five years. The higher the term for which funds are committed, the higher the interest paid. To take advantage of the various interest rates offered for different periods, investors can follow a strategy known as the CD ladder.

A CD ladder strategy is followed by investors who value the safety of their principal and income. This strategy also provides investors with steady cash flow as the CDs will mature at different times. An investor that incorporates this strategy will allocate the same amount of funds across CDs with different maturities. This way, s/he benefits from the higher interest rates of longer-term CDs and does not have to repeatedly renew a short-term certificate of deposit that holds all his or her funds.

Investors that put all their funds in one CD may miss out on higher interest rates that may result while their funds are locked away. With a CD ladder, however, the investor can take advantage of short-term interest rates by reinvesting proceeds from maturing CDs into newer CDs with higher interest rates. On the other hand, if interest rates fall, CD holders still enjoy the benefits of the high interest rates that their existing long-term CDs provide. A CD ladder, thus, provides regular opportunities to reinvest cash as the CDs mature, while reducing interest rate risk.

In the event that an emergency ensues and an investor needs cash, the laddering strategy ensures that the investor consistently has a CD maturing, thereby, reducing liquidity risk.

For example, an investor has $40,000 to invest. Rather than putting the entire funds in one CD, he decides to put $10,000 in each of four certificates of deposit maturing in 6 months, 12 months, 18 months, and 24 months. The table below illustrates how a CD laddering strategy works:

Today

After 6 months, the 6-mth CD matures and the investor reinvests the proceeds in a 24-mth CD. The time left to maturity for all the CDs is …

After another 6 months has passed, the original 12-month CD in the first column matures and the proceeds are reinvested in a 24-mth CD. At this time, the maturity term for all CDs is…

18 months from the initial date of purchase is here and the original 18-month bond matures. The investor purchases a 24-mth CD. After 18 months, the time to maturity on the CDs is…

Another 6 months later and 24 months in aggregate…

And the cycle of reinvesting proceeds continues semi-annually…

6-mth CD

24 months

18 months

12 months

6 months

24 months

12-mth CD

6 months

24 months

18 months

12 months

6 months

18-mth CD

12 months

6 months

24 months

18 months

12 months

24-mth CD

18 months

12 months

6 months

24 months

18 months

 

 

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