Building a CD ladder for today's rates
October 25, 2011
Laddering CD lengths is a traditional way of getting the most out of CD rates, but today's CD rates are anything but traditional. It may not be time to jump off the CD ladder, but it may be time to bend it a little.
Managing CD rates: The traditional ladder
Interest rates on CDs represent a trade-off: the longer you are willing to lock up your money, the more interest you will earn. However, there is a cost to locking up your money in a long-term CD. You might have a need for cash before a long-term CD matures, or you could find yourself locked into a low interest rate while CD rates are rising.
A CD ladder is a way of managing the competing goals of earning higher interest and retaining some flexibility. With a CD ladder, you put money into a series of different CDs with different maturity dates. Those maturity dates are like steps on the ladder--as you reach each step you will get some liquidity. A laddered portfolio of CDs means you will get liquidity in regular increments, but you will still be able to earn higher interest rates by having some of your money in long-term CDs.
The most effective form of CD ladder is one that is constructed over time. Suppose you put some money into five-year CDs once a year for four straight years. You would now have a portfolio that will provide some liquidity each year going forward, and yet you would still be earning the higher interest rates associated five-year CDs.
Recommendations for today's CD rates
Today's CD rate environment has diminished the incentive of locking into longer-term CDs. For one thing, the risk of missing out on rising interest rates is exacerbated when interest rates are low, and current interest rates are historically low. For another thing, longer-term CD rates offer less of a premium over shorter-term CDs these days. There's less point in taking the next step up the ladder when the rungs are so close together. For example, two years ago, five-year CD rates were about 2 percent higher than one-month CD rates; today, that premium is less than 1.2 percent.
So here are some tips for bending the CD ladder to fit today's conditions:
- Shop for the highest short-term CD rates you can find. As of mid-October, the average five-year CD was paying 1.27 percent. If you shop around, you can find one-year CDs paying nearly as much. This would allow you to bend your CD ladder towards the short end with nearly as much interest.
- Only buy long-term CDs with exceptional rates. You can also shop for above-average interest rates on long-term CDs, but you should make sure those rates are high enough to cushion against the risk of rates rising from their historically low levels in the next five years.
- Look for low termination penalties. Banks sometimes offer CDs with relatively minor penalties for early withdrawals. If you can find those offers plus competitive rates, you can reduce the risks associated with locking into a long-term CD.
Even in today's low interest rate environment, laddering CDs remains a viable strategy--it's just that the ladder may have to be a little more flexible than usual.