Many savers need to get as much income as they can from their savings. If you can afford to lock up your money for a period of time, then a certificate of deposit can be a good way to get a higher interest rate from your bank. It’s easy to open a new CD with most banking institutions, and you’ll find a wide variety of different terms and rates to meet your needs.
One way to get even more income from your savings is to use what’s known as a CD ladder strategy. To use this method, you’ll need to open a number of different CD accounts with different maturity dates. This lets you take advantage of the higher APYs that many banks offer on longer-term CDs without locking up every penny of your cash for a long period of time. Below, we’ll look more closely at CD ladders and how to build a strategy that will work for you.
The basics of CDs
When you open a certificate of deposit, you’re essentially making a loan to your bank. You agree to deposit your money with the bank for a fixed period of time. In exchange, your bank agrees to pay you interest at regular intervals and then return your entire principal investment when the CD matures.
You can typically find CDs that will offer terms of whatever length of time you’d like. Some CDs mature in as little as a single month, while it’s also possible to find CDs with terms of 10 years or even longer. Nearly all banks will give you options for CDs ranging from three months to five years, with plenty of choices in between.
Most of the time, the longer the maturity on a CD is, the higher the APY on the CD will be. Recently, for example, the difference between one-year CD rates and five-year CD rates has been about half a percentage point. In the past, that difference was even larger, sometimes reaching a full percentage point or even more. That difference might not sound like much, but on a $10,000 CD, getting an extra half percentage point means $50 extra in income each year. For a $100,000 CD, that’s $500 in extra interest.
How CD ladders work
Ideally, you’d like to get the high rates that long-term CDs offer, but you might not want to lock up your savings for that long. If you need more immediate access to a portion of your savings, then a CD ladder can give you the best of both worlds.
Specifically, a CD-laddering strategy has you owning several different CDs that match up well with your cash and income needs. When you’re first getting started with CD ladders, you’ll buy CDs with different maturities. It’s typical to put equal amounts into each CD, given that most people have cash needs that are relatively consistent over time. Some prefer to use only a portion of their savings toward opening CDs initially, and then add further CD accounts later on to provide even more financial flexibility.
Let’s look at how this works out in real life. In this example, you have $100,000 to invest at the beginning of 2019. Your bank pays 2.5% on a one-year CD, 2.75% on two- to four-year CDs, and 3% on a five-year CD. To build a bond ladder immediately, you could open five CD accounts for $20,000 each, with maturities in 2020, 2021, 2022, 2023, and 2024.
Alternatively, if you wanted to spread out your money further, you could invest $25,000 of your $100,000 total now, opening five $5,000 CDs. Then three months from now, you could do the same thing, and then do so every three months until you’ve invested all your money in CDs. The end result would be 20 CDs of $5,000 each, with one CD coming due every quarter between early 2020 and late 2024.
Why CD laddering is smart
CD ladders have two key advantages: They maximize your long-term interest, and they give you regular access to a portion of your cash. Consider the simple five-CD bond ladder above. It pays an average of 2.75% in interest, which is above the 2.5% offered on a one-year CD. Yet it gives you access as early as 2020 to the $20,000 in savings in the one-year CD. If you’ve planned well, then having that much access should match up with your anticipated financial needs.
If you need to spend the cash in the maturing CD, then you simply withdraw it and avoid any penalty for early withdrawal. But the true power of the CD ladder comes if you reinvest that cash. The next step in a CD laddering strategy is to reinvest any maturing CD in the longest term of the ladder. For instance, in our example, you’d reinvest the 2020 CD in a five-year CD maturing in 2025. That would then give you a portfolio of CDs maturing every year from 2021 to 2025.
Notice that if you reinvest, then your overall interest rate on the CD ladder should go up. Even if rates stay the same, your new five-year CD will carry a 3% APY, which is better than the 2.5% APY on the CD that just matured. That boosts your average rate from 2.75% to 2.85%. Over time, you’ll eventually end up with an ongoing progression of five-year CDs coming due one per year, maxing out your interest at 3% based on current rates.
Why CD ladders aren’t perfect
To be clear, CD laddering isn’t ideal for every purpose. If you’re looking to invest money for the long run, then you can typically get better returns by using more aggressive investments like stocks. CDs are completely safe from principal loss, so they’re useful for short-term cash needs, but if you truly believe that you’ll be able to keep reinvesting your CD ladder indefinitely, it makes sense to look at stock alternatives to boost your overall returns — again, if you don’t need the income.
Also, if you goof up and need money on a schedule that’s different from how you’ve set up the CD ladder, then you can end up having to pay early withdrawal penalties. Depending on the bank, that can cost you several months or even a year or more in interest — a costly mistake that you’ll want to avoid if at all possible.
Be smart with your money
Even with these caveats, having a nest egg of secure savings is important, and if you want to get the most income from it that you can, CD ladders are a good strategy to use. By setting up a CD ladder, you’ll be able to boost your effective interest rate while still keeping the financial flexibility to get access to a portion of your money on a regular basis. That’s exactly what many savers want.
View more information: https://www.fool.com/the-ascent/banks/what-is-cd-laddering/