What is a CD Ladder?
A CD, which stands for “certificate of deposit,” works in a similar way to a savings account. It’s a tool for both saving money and accruing interest on that savings. A CD is also insured by the Federal Deposit Insurance Corporation (FDIC), just like a traditional savings account. However, CDs operate somewhat differently than savings accounts in a few respects.
For one, CDs typically have higher fixed interest rates than savings accounts. This is because funds deposited into a CD are more secure from the perspective of the financial institution issuing the account. Unlike a traditional savings account, you can only withdraw funds without penalty from a CD on a fixed date known as its “maturity date.”
You can obtain CDs from most established financial institutions. Most people open them with a bank or credit union, but some non-traditional financial institutions offer CDs as well.
CDs come in different term lengths, which can be as short as a month or as long as several years. These different term lengths are what enable investors to create what are known as CD ladders.
What is a CD Ladder?
A CD ladder isn’t a product offered by a bank or financial instruction, per se. Instead, it’s an investment strategy that involves opening CDs with staggered maturity dates to reduce risk, increase returns and obtain more liquidity with your savings.
When an investor wants to create a CD ladder, they open multiple CD accounts, each with a different term length. They then split a lump sum of money between each of those accounts.
For example, if you want to invest $10,000 in a CD ladder, you might open five separate CD accounts with term lengths of one, two, three, four and five years. You would then place $2,000 in each of those accounts.
Once the first CD matures, you can re-invest the funds into a 5-year CD to earn even more interest. However, you also have the option to withdraw funds without penalty when each CD reaches its maturity date. If you reinvest the money on all your CD accounts once they mature, you’ll eventually have five CDs with long terms and high interest rates and yearly access to at least some of your funds.
CD Ladder Advantages
Building a CD ladder is an alternative to investing in a CD in the traditional way, which involves renewing a single CD that holds your entire savings investment. While investing in a single CD may still be worthwhile, it is much more restrictive. You may opt for shorter terms so you can access your money sooner, which means sacrificing some of the gains that could come with a longer-term CD.
There are four key advantages when investing in a CD ladder.
Deposits are FDIC insured
Putting your money into a CD is much safer than investing it in the stock market. This is because money placed in a CD is insured by the FDIC, whereas money invested in the stock market is not. Even a diversified stock portfolio is at some risk of loss. You cannot completely eliminate systemic risk in the market, even if you hedge against it.
The FDIC insures deposits of up to $250,000 per account holder. With a partner, you could potentially insure a joint account of up to $500,000.
Furthermore, much like a regular savings account, a traditional CD cannot lose value. The only time you could suffer a potential loss is if you withdraw money from your CD before its maturity date.
Flexibility with your savings
Using the CD ladder strategy means you can split up your savings any way you choose. You don’t necessarily have to break up a lump sum of money into even amounts like in the example above.
Instead, you could place more of your savings into your initial long-term CDs to earn more interest. You would still have access to some of your funds at regular intervals, but you could earn more over the long run.
Likewise, you could place more of your savings into your initial shorter-term CDs to get access to more of your funds sooner. This way, you could still take advantage of high interest rates on your longer-term CDs but ensure that much of your saving is available when you need it.
Many investors choose to keep some of their savings in a high-yield savings account in addition to the portion invested in their CD ladder. This keeps a sizable portion of their savings available for withdrawal in case of emergencies while allowing them to reinvest in their CD ladder repeatedly.
Take advantage of better interest rates
Building a CD ladder lets you take advantage of high interest rates when you otherwise might not be able to. Plenty of people would like to take advantage of the high interest rates associated with a long-term CD, but because it means locking away funds for such a long period of time, so it’s less risky for them to opt for a shorter term and lower interest rate.
CD laddering gives you the best of both worlds. It allows you to access those higher interest rates while keeping some of your funds available. If interest rates go up while your money is invested, you can count on even higher yields when it comes time to reinvest.
Get access to your savings
The key advantage of building a CD ladder is maintaining access to your savings. If you re-invest each CD as it matures, you’ll still only be able to access your funds once a year, though, so it’s important to plan around this schedule so you don’t run into a situation where you don’t have access to emergency funds.
If liquidity is a serious concern for you, consider building a short-term CD ladder. CD terms can be a short as 1 month or less. Interest rates on these short-term investments tend to be rather low, but building a short-term CD ladder would provide you access to funds multiple times per year.
CD Ladder Disadvantages
Investing in a CD ladder may make sense if you’re seeking a low-risk way to grow your savings. It typically gives you the opportunity to access better interest rates than with a traditional savings account.
Nonetheless, this strategy isn’t for everyone. It all depends on your goals and your financial situation. There are a few disadvantages to CD laddering.
Limited access to funds
Perhaps the biggest issue people have with building a CD ladder — and with CDs in general — is that it limits access to your funds. Even a short-term CD ladder means your savings won’t be accessible for some time without a withdrawal penalty.
It’s important to keep some of your savings accessible in case of an emergency. If you rely heavily on your savings, you may wish to keep it in a traditional savings account or at least keep a portion of it in an accessible account.
Moderate interest rate risk
When you invest in a CD, you usually lock in an interest rate. That means you could miss out on an opportunity for higher yields if interest rates rise after you open your CDs.
CD ladders tend to alleviate some of this problem by enabling you to re-invest your money at certain intervals, potentially taking advantage of better rates. Regardless, you can’t predict where interest rates will be when each one of your CDs matures.
Lower potential returns than the stock market
For many people, the fact that a CD doesn’t go down in value is one of the biggest advantages, but low risk typically translates to smaller returns. You could see greater returns for your money by investing it in the stock market, although there is the chance that you could lose some or even all your investment.
Whether you invest in a CD or in a stock portfolio depends entirely on your tolerance for risk. However, it’s usually not a good idea to invest your entire savings in the stock market.
How to Build a CD Ladder
Some financial institutions offer tools to help you build your own CD ladder, but you can also do it on your own simply by opening multiple CDs of different term lengths.
First, determine your deposit amount. This is the total amount of money you intend to invest in your CD ladder, which will be divided amongst your CDs.
You’ll then need to determine the term lengths of your CD ladder. If you choose a CD ladder of five, four, three, two and one years, you’ll have access to some of your funds once each year, even if you renew each CD for five-year terms.
Third, decide how you’d like to divide your money. While dividing it evenly amongst your CDs is the most common approach, you may wish to divide the money differently depending on your goals. Placing more money into your first five-year CD will allow you to take advantage of a higher interest rate on more of your savings for longer.
Finally, open your accounts and make your deposits. Once you do this, you don’t have to do anything until your first CD matures. When this happens, you’ll have a choice to either withdraw the money or reinvest it in a longer-term CD.
Keep in mind that re-investing your money once it matures is a key part of the CD ladder strategy.
How to Choose the Best CDs
In most cases, the biggest factor you need to consider when choosing a CD is the interest rate. Some institutions offer higher interest rates than others, while longer-term CDs always have higher interest rates than those with shorter terms.
Nonetheless, you should keep in mind that interest rates fluctuate. You can watch the market and the federal government for clues as to how interest rates will perform. If they are expected to rise soon, you may wish to open your CDs later so you can take advantage of a higher rate.
Minimum deposits and withdrawal fees are two other factors to consider. CDs with high minimum deposits may offer better rates. You may wish to opt for CDs with low withdrawal fees just in case, but if you believe you’ll withdraw your funds, you may be better served by a traditional savings account.
Finally, you must consider which type of CD product works best for your ladder strategy. In most cases, opening traditional CDs is the best way to go. However, some CD products offer no penalties for withdrawals and even provide you with opportunities to take advantage of higher interest rates while your money is still invested.
If you have plenty to invest, you could even consider including one or more jumbo CDs in your ladder. These CDs typically require at least a $50,000 to $100,000 minimum deposit, but they come with substantially higher interest rates than traditional CDs.
The Final Word
If you’re considering a certificate of deposit, building a CD ladder is a strategic way to maintain some liquidity in your savings while taking advantage of higher interest rates than with a traditional savings account. You could see higher potential returns by investing some of your money in the stock market, but CD ladders are a good low-risk option for savers who want higher yields.