What Is A CD Ladder Good For Anyway?
In the world of investments (and in particular, the stock market), there are almost as many opinions as there are assets to invest in.
But there seems to be one piece of advice that unites all the investment aficionados: diversify your portfolio.
It’s recommended to diversify your investments because it spreads your risk out among multiple assets, therefore reducing your risk of losing too much money in any one asset.
Step out of the world of investments and into the world of bank Certificate of Deposits (CDs for short, and you’ll find a similar concept appropriately called a CD ladder.
To understand what a CD ladder is, you first need to know what a CD is.
What Is A Certificate of Deposit?
Before we discuss CD ladders, let’s make sure you know what a CD is.
CDs are a type of savings account that offer higher interest rates than your typical personal savings account.
In exchange for a higher rate, you agree to not touch the funds for a certain time period (called the term length) without paying a significant penalty that mitigates many months of your interest earnings.
The longer term length you agree to on a CD, the better your interest rate is.
Once the term length ends, the CD is said to have hit “maturity”.
CDs are ideal for people with a decent sum of extra cash that they don’t need for a while, as they can get a pretty good return on a federally-insured, relatively safe investment with money that won’t make or break their standard of living.
What Is A CD Ladder?
Alright, let’s go back to diversification.
As you know, money sits untouched in a CD for a fixed amount of time; you can choose what term length you want you CD to be.
Some investors take advantage of this and invest in multiple CDs, each with different term lengths and thus different interest rates.
This is a CD ladder.
One great way investors create a CD ladder is by making each CD mature a year later than the last. For example, and investor might invest in
- A 1 year CD
- A 2 year CD
- A 3 year CD
- A 4 year CD
- A 5 year CD
Each year, one CD matures. So even though your highest-interest CD is many years away from being accessible, you have a newly-maturing CD every year.
Side note: for simplicity’s sake, we’ll carry this example through the rest of this article.
The Pros Of A CD Ladder
This unique method of investing bestows several benefits upon you.
If you opened a single 5-year CD and stuffed it with $10,000, you’d earn a nice return on your investment.
Problem is, you can’t touch that cash nor can you withdraw your interest earnings for half a decade.
By laddering your CDs, you increase your money’s accessibility. Despite having multiple CDs that won’t mature for years, you regain access to some of your money each year.
This feeds directly into the next benefit…
Regular Reinvestment Opportunities
Earlier, we talked about structuring a CD ladder in a way that would allow 1 CD to mature each year. We illustrated with an example of a 5-CD ladder.
But the ladder doesn’t have to stop there; in fact, you can make climb the CD ladder indefinitely by reinvesting your earnings into a new CD each year.
If “X” represents the term length of your longest CD, then you could keep climbing the CD ladder by reinvesting the funds from each year’s maturing CD into a new CD of “X” length.
Let’s use our earlier scenario as an example: every year, when one of your CDs matures, pull out the money and reinvest in a new 5-year CD.
Not only do you continue to gain access to your funds each year, but you also get the best interest rate at the time you reinvest since you’re choosing a longer-term CD.
Long-Term Interest Rates, But Short Term Maturities
All the benefits of CD ladders compound with each other.
At first, your CD ladder will have a wide range of interest rates: the longer ones will be much higher than the short-term ones.
However, as your initial short-term CDs come due, you can continue climbing your CD ladder by reinvesting the proceeds into new 5-year CDs (as you just learned).
After the initial 5 years, you’ll finally have your high-interest 5-year CD mature.
By this point, however, all your CDs (assuming you reinvested in a new 5-year CD each year) will be 5-year CDs.
Long story short: You’ll have a CD mature every year like usual. BUT after 5 years, ALL your CDs will technically be 5-year CDs.
Yes, that means exactly what you’re thinking: you’ll have short-term CD accessibility at long-term CD interest rates.
Now that’s a pretty good deal!
Helps With Financial Responsibility
This is less because of CD ladders and more due to the nature of CDs themselves, but CDs can be great tools for removing the temptation to spend money irresponsibly.
With the bank barring you from your money at the cost of most of your interest earnings, you’ll think twice before trying to make an impulse purchase using your CD money.
The Cons Of A CD Ladder
CD ladders aren’t without their drawbacks.
Accessible, But Not THAT Accessible
Laddering your CDs gives you the best of both worlds: short-term maturity with long-term rates.
However, that doesn’t change the fact that CDs are relatively illiquid (in other words, you can’t convert your CD back to cash very easily).
Once you’ve invested in a CD, you can’t touch that money no matter if you have or haven’t created a CD ladder.
If you have a sudden emergency that requires you have a lot of ready-to-use cash (such as a bad car accident), you’ll be out of luck if you don’t want pay a penalty to get your cash back.
Most of the time, the penalty for early CD withdrawal will negate most of the interest you made while invested in the CD.
So if you don’t have a couple thousands that you don’t need, a CD ladder might not be the optimal investment choice since you need a decent sum of money to make them worthwhile.
Lower Returns Than Other Investments
Unlike many investments you can get outside a bank, CDs are FDIC-insured so you don’t need to worry about your money vanishing.
However, this (among other factors that make CDs safer investments than stocks) naturally means that you can’t make as much as you could with riskier investments.
Some of the highest CD interest rates today are in the low 3% area; contrast that with the Dow Jones Industrial Average’s commonly-cited average return of 7%, and you’re looking at a world of difference in terms of what your money could be earning you.
Interest Rate Risk
Once you invest in a CD, you are locked into it’s interest rate for the length of the CD’s term.
Such circumstances can be good if interest rates suddenly plummet.
But if you store away your money into a 5-year CD and interest rates increase in a year, you lose out on more potential return on your investment.
Of course, a CD ladder minimize this by spreading such interest rate risk across multiple CD term lengths. However, even for a very-short term CD (such as a 6 month CD, which could actually have a lower interest rate than a high-yield savings account), interest rates could increase tomorrow and you’ll miss out on interest earnings.
CD Laddering For The Short-Term
The great thing about CD ladders is they can be used for both the short term and the long term depending on your needs.
CD Laddering For The Short-Term
Everyone wants it all: secure investments, high returns, and easy access to your money.
While there’s no product that can provide it all (or otherwise said product would be the only thing anyone would invest in), CD ladders do everything well.
Every year, you gain access to your original CD investment plus some interest. Although the best decision in most cases would be to reinvest everything into another CD and keep the ladder going you don’t always have to.
In fact, you create a system where a CD ladder serves as a “yearly allowance” for yourself.
To illustrate: let’s say you want to allot yourself $2,000 a year for fun money. To do so, you invest $2,000 in CDs with 1-year staggered maturity dates, from a 1-year CD all the way to a 10-year CD.
Each year, your allotment becomes accessible as the CD comes due. But as a bonus, you get some interest!
And as the longer-term CDs come due, your interest earnings increase.
This does two things:
- It keeps you responsible since you’re getting a fixed sum of your money each year
- You earn some interest which could be added to your self-imposed allowance
A CD ladder can almost serve as an extremely reliable accountability partner that pays you for your diligent financial habits.
CD Laddering For The Long-Term
CD ladders truly shine when it comes to the long-term.
Since you’re restricted from touching the money until a CD matures, it’s easier to avoid the temptation of spending your home-buying fund on an expensive getaway (albeit not completely, as you gain access to funds each year).
While your financial goal is still very far away (such as retirement), you reinvest your maturing CD into a new long-term CD at the top of your ladder each year.
As you earn interest on each CD, you take advantage of compounding by reinvesting principal AND interest into each new CD.
On top of that, increasing interest rates (since you’ll have a long-term CD maturing every year) means you’ll have even MORE interest returns to work with.
Once your financial goal is the same amount of time away as the term length of your longest CD, you’d then stop the reinvestment process. That way, you’ll have all your money plus the large amount of interest on hand to buy that house or retire comfortably.
Climb The Ladder To Wealth
There are tons of investment vehicles out there with all manner of risks and rewards, from savings accounts to stocks to real estate.
And although many people are willing to risk their money for a chance at solid returns on their investments, some people simply want a secure way to grow their money.
If that sounds like you, CD ladders could be a valuable, low-risk asset in your arsenal of money-making investments.
CD ladders bring you the best of short- and long-term CDs: you earn great interest rates while having access to your money on a yearly basis (after a few years, of course).
In addition, they strike a great balance between risky and safe investments: they provide a higher return that even many high-yield savings accounts, but your money isn’t at risk of being lost like it is in the stock market.
Just remember: any time you’re considering new investment opportunities, it’s a great idea to speak with a financial advisor.
They know the ins and outs of most financial products; they can help you navigate the complicated world of investing and help you build an investment portfolio that’s optimized for your individual situation.