What is a 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.

Key Takeaways

  • A CD ladder can decrease both interest rate and re-investment risks for CDs.
  • The ladder is created by allocating the same amount of funds across CDs with different maturities.
  • With a laddered CD portfolio an investor can still achieve quarterly payments, but with a much higher total portfolio rate of return.

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.

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What Is A CD Ladder?

How to Build a CD Ladder

Let's say an investor has $20,000 to invest and wants to build a four year CD ladder.

Step 1: Open Separate CDs

Rather than putting the entire funds in one CD, the investor puts $5,000 in each of four CDs maturing in one, two, three, and four years. The investor looks to find banks with the best rates on CDs before investing the funds. What the investor is starts with is:

  • $5,000 in a 1-year CD
  • $5,000 in a 2-year CD
  • $5,000 in a 3-year CD
  • $5,000 in a 4-year CD

Step 2: Renew and Convert Each CD at Maturity

As each CD matures, the investor will renew it as a 4-year CD. By doing so, after four years the investor will have four, four-year CDs but with only one of their CDs maturing annually.

If the investor had opened all of their CDs in January 2019, setting up the ladder would look like:

  • January 2020: renew the 1-year CD into a 4-year CD
  • January 2021: renew the 2-year CD into a 4-year CD
  • January 2022: renew the 3-year CD into a 4-year CD
  • January 2023: renew the 4-year CD into a new 4-year CD

This would allow the investor to leverage the higher interest rates on the longer term CDs while building the ladder and also have access to pulling out 25% of their funds from the ladder per year without penalty by virtue of one CD maturing each year.

Mini CD Ladders

A mini CD ladder is the same concept as a regular CD ladder but with shorter term CDs. You could build a CD ladder out of 3-month, 6-month, 9-month and 1-year CDs to deploy the same strategy. Keep in mind though that by building a ladder against shorter term CDs that the interest rates you'll be able to get will be lower.

Benefits of a 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. By spreading the investment over CDs with varying maturities, the investor 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 their funds.

CDs also offer FDIC insurance against default should a bank become insolvent. With the exception of U.S. Treasury bonds, which are also backed by the federal government, no other vehicle offers such protection for fixed-income investors.

Additionally, by laddering CDs, investors are able to customize their aggregate (or total) rate of interest, generally on the upside. For example, an investor may only purchase three-month CDs to produce quarterly cash flows, realizing a relatively low rate of return. With a laddered CD portfolio, however, they can still achieve quarterly payments, but with a much higher total portfolio rate of return, because longer maturity CDs generally pay higher interest.

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.

The Bottom Line

All in all, like any other investment, the practice of using laddered CDs depends entirely on your personal financial goals. Generally speaking, they are great for people who want safety of capital, predictable cash flows and simplicity. CDs are very easy to understand, to access and to structure to meet your financial goals.

On the other hand, the rates of return for CDs are generally low due to the safety they offer. Moreover, they offer no special tax treatment to save money on local, state or federal taxes; therefore, if you are in a high tax bracket, they are difficult to justify. If you are in a low tax bracket, they make a lot more sense.

Just keep in mind that the safest course of action with CDs is to go through your bank and make sure your deposits are covered by FDIC insurance limits. If you decide to go through a brokerage house, understand that you have introduced a variety of risky variables like commissions, the questionable motivations of salespeople (the broker) and potential loss of principal. Keep it simple and reap the benefits.