Basics of a CD Ladder Strategy
A Certificate of Deposit, commonly referred to as a CD, is a financial product that is offered by banks and credit unions, which makes them a secure and safe place to keep money that you aren’t planning to spend anytime soon. To initiate a CD, there is usually a minimum amount you need to deposit.
A CD is different from other types of savings or money market accounts, because you are assessed penalties if money is removed before the end of the term. By agreeing not to withdraw any money during the term of the CD, you will receive a higher interest return than other types of deposit accounts. A CD is a guarantee that you will get the return on the agreed rate regardless if interest rates fluctuate.
What is CD Laddering?
Before you purchase a CD, it is good to know about a common investment strategy, CD laddering, to help you potentially maximize your earnings. Laddering simply means that you hold CD’s with different maturity dates and annual yields.
Suppose that you purchase a five-year traditional CD with an initial deposit of $100,000. Although the longer the term, the higher the interest rate offered, five years can be a long time to part with one’s money. A CD with a five-year term is more attractive because of higher interest rates, but it comes with a disadvantage. Because there are penalties associated with withdrawing money from a CD before its term is over, the five-year term CD could be risky.
However, if you use a laddering strategy you would buy five $20,000 CD’s with your $100,000 with terms of five years, four years, three years, two years and one year. When the one-year term CD reaches maturity you then purchase another five-year CD. When the two-year term CD reaches maturity you then purchase another five-year CD. Repeat this step every year until you have five five-year term CD’s.
Laddering is a strategy that helps you earn higher interest rates on your money and provides you a greater flexibility because when each CD matures you have the opportunity to renew it or use the money for something else.
- Liquidity – Cash is available at more frequent intervals than buying one long-term CD.
- Better Interest Rates – Once the ladder is established, you get to choose longer-term CD’s that offer a higher interest rate.
- Peace of Mind – When interest rates rise, you will be able to purchase CD’s at the higher rates each year. If interest rates fall, the longer term CD’s you previously purchased were purchase at higher rates.