Managing CD rates: reverse laddering your way to a new home
June 15, 2011
Once you buy a home, you find yourself buying home maintenance tools that you didn't need as an apartment-dweller, such as a ladder. Actually though, even before you buy a home, a CD ladder can help you build the down payment you'll need for your mortgage.
Normally, laddering CD rates involves buying a series of CDs with different maturity dates. For down payment purchases, you need something you can think of as a reverse ladder: CDs purchased at different times, but with the same maturity date.
Budgeting your down payment
Because people generally save for a down payment bit-by-bit, CDs might not seem like the natural choice for these savings. However, given the size of many down payments, there should be an opportunity to take advantage of higher CD rates - and use the reverse laddering technique - if you budget your down payment savings carefully.
Consider the size of a typical down payment. Depending on your situation, you may have to put down as much as 20 percent of the purchase price in order to buy a house. According to the National Association of Realtors, the average price of a home in the U.S. is about $160,000. A 20 percent down payment on a house at that price would be $32,000.
For most people, $32,000 isn't an amount they can scrape together in a matter of a few weeks or months. It may take a few years to save that amount - plenty of time to take advantage of higher CD rates if they use reverse laddering.
Making the most of CD rates: the reverse ladder
Here's an example of building a reverse ladder. Chris and Tina are saving for a $32,000 down payment. They get paid every two weeks, and between them they figure they can save $500 from every paycheck. At that rate, it will take them 128 weeks, or nearly two and a half years, to accumulate $32,000.
Initially, Chris and Tina put their savings into a money market account. However, they plan their savings as a series of six-month targets. After the first six months, they have accumulated $6,500 - enough to be worth putting in a CD. They have two years left of saving their down payment, so they take this money and buy a two-year CD. After another six months, they have another $6,500, so they buy another CD - this one for one-and-a-half years, and so on.
In this way, Chris and Tina are assembling a reverse ladder - CDs with the same maturity date, but purchased at different times. In the process, they earn more than they would in a savings or money market account.
If you decide to use the reverse-ladder technique for saving a down payment, don't feel you have to be locked into the same bank for each of the CDs. Compare CD rates to get the best deal each time you open a new CD. Also, be aware of the early-withdrawal penalties, so you can know your options for taking of advantage of an opportunity a little earlier than planned.
Reverse laddering should help you save for your down payment a little more quickly - and who knows, you might have a little left over to buy a real ladder for your new home.