They’re Back! How to Use a CD Ladder

With high inflation becoming stubbornly persistent, the U.S. Federal Reserve has been communicating that high-interest rates might be here to stay for longer than most financial experts previously believed. While that will have some short-term negative effects on business and the stock market, the good news is that this may be a once-in-a-decade opportunity for conservative investors.

In particular, I’m talking about CDs. A CD or “certificate of deposit” is simply an agreement with a financial institution to lock up your money for a certain number of months or years. In return, you’ll receive a fixed rate of interest that’s comparatively higher than the APR you’d receive from a high-yield savings account.

If you’re a younger investor, chances are that you’ve probably never heard of a CD. This is because CDs have paid next to nothing since interest rates flat-lined ever since the Great Recession of 2008. However, now that the Fed seems to be returning to an environment of high-interest rates, this may be a good time to shake the dust off of them.

However, rather than go to your local bank and open up a regular CD, I’d like to introduce you to a more effective strategy called CD laddering. CD ladders were very popular when interest rates were higher, and it’s fair to say that they seem to be making a big comeback. In this post, we’ll talk about what a CD ladder is, how it works, and what the benefits might be of utilizing them while rates continue to remain high.

What is a CD Ladder?

A CD ladder is a systematic series of separate CDs that expire at various intervals throughout a given time frame. This will generally be anywhere from one to five years.

How Does a CD Ladder Work?

Here’s an example. Let’s say you’ve got $10,000 that you’d like to invest. Rather than invest the full $10,000 into any one CD, a ladder would be constructed by putting $2,500 into four separate CDs with the following maturity dates:

  • 3 months
  • 6 months
  • 9 months
  • 12 months

After 3 months from the start, the first CD will mature (meaning the money becomes unlocked) and pay out the promised interest. The next thing you’d do is renew the CD for 12 months. That way, it will now mature 3 months after the original 12-month CD. As far as the interest you received, you could either keep it as spending cash or reinvest it when you renew (which will of course increase its earnings potential).

After 6 months from the start, the second CD will mature. Again, you’d reinvest this CD for 12 months – either with or without the interest at your discretion. Now it will mature 3 months after the CD from the previous step.

This cycle will continue over and over again creating a systematic cascade of one CD maturing every 3 months and paying out interest. As the name suggests, it will be like climbing the rungs on a ladder where your earnings increase the further you go.

What are the Benefits of a CD Ladder?

You might be wondering: Why go through the trouble of opening multiple CDs? Why not just one long-term CD at a given interest rate? Here’s why.

Better Interest Rate Potential

Suppose you opened a 2-year CD in the middle of 2022. Chances are the best APR you could have gotten was between 2 and 3%. Skip ahead 6 months and now you can find shorter-term CDs between 4 and 5%. However, if your money was locked up in that first 2-year CD, then you’d miss out on this opportunity until it matures. CD ladders give you a chance to capture rising interest rates and take advantage of any “special” promo rates.

Once the Federal Reserve starts to pull back and interest rates begin to decrease, a CD ladder can also help you hold on to higher rates for longer. For instance, when your next CD matures, you could renew it for the longest CD available at the time (most likely 5 years). That will enable you to hold the most attractive rate for longer.

Frees Up Cash Flow

Putting money into a CD locks it up for the term. Otherwise, you have to pay a penalty to break it which is usually forfeiture of some or all of the interest. Laddering helps avoid this problem by staggering the maturity dates and creating multiple opportunities throughout the year where the funds will be accessible.

No Risk of Market Loss

Since CDs are products issued by banks, there’s virtually no risk. Unlike the stock market or even the bond market where the underlying asset price can fluctuate, your principal will remain the same and you can count on receiving a fixed rate of interest.

FDIC Insured

It’s unlikely, but if anything were to happen to the financial institution that issued the CD, you’re insured by the Federal government up to $250,000. This may not seem like a big deal, but it’s important when you consider how many people lost money due to the collapse and bankruptcy of crypto trading platforms (since they are not regulated or insured by FDIC).

How Do I Make a CD Ladder?

If you’d like to use CD laddering, then you have two potential options.

The first is to construct your own ladder. This can be done by doing the following:

  1. Determine the longest CD you’d like to hold.
  2. Research what the banks are offering. Although you don’t have to necessarily, it may be easier to hold all of your CDs under the same institution.
  3. Decide how much you’d like to invest. Check with the banks to make sure you’ll meet their minimum deposit requirements.
  4. Open an account (if you don’t have one already) and invest.

The second option is to invest in a pre-made CD ladder. Some financial institutions have removed the hassle of assembling them and offer readily available models. For example, Fidelity has several different CD models available to its clients. They even come with built-in features like automatic renewals and reinvestment of the interest so that you don’t have to take any manual action yourself.

Earn High Interest While You Can

Interest rates may be climbing up and creating good places to park your money. But remember that for most of the economy, high-interest rates are bad – business loans, mortgage rates, credit cards, etc. Therefore, don’t expect these above-average rates to last forever. Once inflation shows signs that it’s going down, the Fed will likely reverse rates and cause CD rates to drop.

For this reason, it would be to your benefit to take full advantage of this opportunity while you can. To do that, take a good look at your budget and determine how much you can afford to set aside each month. In fact, if you could cut back on unnecessary purchases and find even more money, that would be better. The sooner you can lock into these high rates, the more you stand to earn.

Featured image credit: Unsplash

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