How to build a CD ladder? It's a great question — unless you have no idea what a CD “ladder” even is. Let's start at the beginning. A CD ladder is a method of staggering the maturity dates of certificates of deposits so you can invest your money safely and still keep some of it easily available for emergencies.
The Federal Deposit Insurance Corporation (FDIC) insures certificates of deposit (or time deposits) just like they insure savings accounts — so they are just as safe.
However, CD rates are higher than a savings account rates because of the reduced liquidity — you have to tie up your money for a period of three months to six years. Of course, these being the dog days of quantitative easing, those higher CD rates can still be counted on very few fingers of a single hand.
And so you wonder: Could there be a way around that, a way to capture a higher CD rate without having your money in a prison cell for which they have thrown away the key?
The CD ladder is the way around that liquidity problem.
The ladder's interesting history
The concept of laddering originated in the arena of bond investing. (In case you are wondering, more money worldwide is invested in bonds than any other investment vehicle, and it isn't even close.)
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Each bond has a fixed maturity date. (A bond is simply a loan, for which interest is paid quarterly and the original principal gets repaid in a lump sum at some point in the future, called the maturity date.)
As an example, IBM Corporation has 10 different bonds outstanding today, maturing in September 2017, February 2018, October 2018, and so forth, all the way up to November 2025. As a bond investor, you would receive an interest check every quarter, but you wouldn't get your money back until that bond's specific maturity date.
You can sell your bonds on the open market, pretty much like mutual funds and stocks, only the process is not nearly as efficient (or cheap), and the amount you get from the sale may be far different from the maturity amount.
Bond investors, therefore, developed a strategy called laddering or layering. In a nutshell, laddering involves buying bonds with staggered maturity dates. This strategy gives you a steady stream of maturing bonds rather than a single, big sum tied up until some date far into the future.
Well, in some ways, certificates of deposit (CDs) function like bonds held to maturity and, therefore, it is no surprise that laddering became a viable strategy to help maintain some access to the amounts on deposit in CD investments as well.
The benefits of laddering CDs
Why has laddering become such an established strategy to invest in bonds, CDs and other investments with fixed interest rates and fixed maturity dates? Here are some of the benefits:
1. Great liquidity: Once you are up and running (explained more in the example below) you will have investments maturing on an evenly spread out timeline. That eliminates the dilemma of not being able to get at your money should something unforeseen happen. Should you not need the money, you simply “roll over” the investment, tacking the money back on the end of the ladder, so to speak.
2. Higher return: You get higher CD rates the longer you are willing to tie up your money. With a ladder, you will end up having a string of max term/max yield CDs, which still mature each quarter (or whichever period you choose to have them mature).
Great flexibility and great returns — relatively speaking, of course — how can you beat that?
In addition, there is another subtle benefit CD ladders offer:
3. Coverage against interest rate risk: If there is one thing you know by now, it's that CD rates fluctuate constantly. They never stay the same. In a climate of dropping interest rates, staggering the maturity dates of your CDs will protect you by allowing you to capture interest rates on your rollovers before they reach the low point of your last rollover. Likewise, when interest rates start rising again, you won't have to miss out while your investment is stuck in a single, low-interest-rate CD.
An example of how to ladder CDs
Let's say you have $20,000 to invest and you decide you want to have access to some of the money once a quarter, at which time you have the option of withdrawing it with no penalty or rolling it over into another CD.
You can choose the maturity date (sometimes referred to as a liquidity event) of a certificate of deposit. They are typically offered in three-, six- and nine-month maturities, followed by one-, three- and five-year maturities. The longer the period, the higher the yield. A three-month CD might yield 0.3 percent while a five-year CD may yield 2.0 percent. The difference between these maturities is the price you pay for the liquidity you want. (CD rates change all the time, so the numbers used in the example might be different for you. However, the relationship between the various numbers generally holds true, no matter the prevailing rates. Therefore, consider the rates in the example in relative, rather than absolute, terms.)
Option A: Unladdered CDs
If you want the benefit of a quarterly liquidity event, your first instinct may be to simply open a three-month CD for the total amount. Then, every quarter, when the CD matures, you reinvest it (roll it over). In this example, your yield would be 0.3 percent per year, or $15 per quarter, $60 per year, and $300 over a five-year period.
Option B: Laddered CDs
To start a CD ladder, you would invest $1,000 in a five-year CD and deposit the remaining $19,000 in a three-month CD.
At the end of the first quarter, you would invest $1,000 in the second five-year CD and roll over the remaining $18,000 for another quarter.
At the end of the next quarter, you would take another $1,000 and put it in another five-year CD and roll over the rest.
You continue with that until the 20th quarter, when all $20,000 will be invested in 20 different CDs, all with the maximum (five-year) maturity.
At the end of the 21st quarter, the very first five-year CD will mature, and you would have the choice to withdraw or roll over the money into another five-year CD.
From then on, you will be earning the maximum CD return on every one of your 20 CDs — and you will still have $1,000 maturing every quarter.
Comparing your options
Using the numbers in the example, Option A will earn $300 in interest over the first five years, while Option B (the ladder) will earn just under $1,200 — almost four times that amount!
This is a simple example. You could make the difference even greater by investing some of your money in intermediate term CDs while you wait for those amounts to be invested in their proper “rungs” of the ladder, but that complicates the calculation without changing the point. The improvement laddering offers over simple CD investing depends on how frequently you need a liquidity event. (The longer you can wait, the less of a difference you would get.)
The underlying point remains the same, though: Laddering your CDs can offer significantly better returns than simple CD investing.
Do you use certificates of deposit as a safe investment? Do you use a CD ladder to profit from interest-rate fluctuations?
William Cowie spent 30 years in senior management (CFO/CEO) before retiring. He has a bachelor's, a master's, and a partial doctorate in management and strategy. Author of the book “The Four Seasons of the Economy,” William also assists medium-sized businesses in the use of the Four Season Strategy to help them capitalize on economic cycles. He runs two blogs: Bite the Bullet Investing (investing) and Drop Dead Money (the economy) and writes for several other blogs in addition.