A certificate of deposit (CD) ladder is a basic technique for managing the interest yield and liquidity of your savings. While the approach has principles that apply under almost any conditions, it does pay to adjust the structure of your CD ladder to the prevailing interest rate and economic environment.
For example, under current conditions, there are five moves you could make with a CD ladder that might prove timely.
How a CD ladder works
In general, CDs represent a trade-off between yield and liquidity. The term of a CD locks up your money for a prescribed period of time. The trade-off is that the longer you consent to lock up your money, the higher the interest rate you earn. For example, according to recent Federal Deposit Insurance Corporation (CD) figures, one month CDs offer an average yield of just 0.06 percent, while 5 year CDs offer an average yield of 0.79 percent.
The drawback of locking your money up for a longer time period is twofold. First, it restricts your ability to get at your money any time you might need it. Second, it commits you to an interest rate that could be a disadvantage if interest rates rise before the CD matures.
Laddering CDs, or buying a series of CDs with a sequence of different maturity dates, helps ease the liquidity restriction of CDs by allowing you to arrange for money to become liquid at regular intervals. This can help you meet occasional needs for cash, and gives you periodic opportunities to reinvest at up-to-date interest rates.
Laddering does not have to entail investing equal amounts at a series of even intervals. You can earmark larger amounts of money for particular time periods, and you can skip over some maturity ranges all together. How you structure a ladder may depend on your needs, but it should also reflect the prevailing financial environment.
5 moves to optimize your CD ladder
With the need to adjust a CD ladder for the prevailing environment in mind, here are five moves you might consider these days:
1. Choose long term CDs
Longer CDs typically have the best CD rates anyway, but there are two particular reasons to weight your ladder more heavily towards longer CDs if your liquidity needs allow for it.
First of all, the Federal Reserve has clearly indicated it expects the return of interest rates to more normal levels to be a very slow process. The Fed does not always have complete control over bank rates, but the near-zero inflation environment seems to support the idea that rates are going to remain low. This means there is less risk of getting stuck in a sub-par interest rate if you buy a long CD.
The second reason is right now the incremental reward for moving out in maturity from four years to five years is the highest of any gap between yearly CD rates, at 18 basis points.
2. Work towards long term yields with short term liquidity
People often think of CD laddering as buying a mix of short term and long term CDs, but another way to do it is to keep buying a long term CD every year, and then rolling them over as they mature. Eventually, this will give you a ladder of CDs that come due every year, but they will all be at high 5 year CD rates rather than a mix of low and high CD rates. This extra yield is especially important in today's low-rate environment.
3. Shop around for the best CD rates
Don't automatically renew your CDs at the same bank. Shop around because conditions may have changed since you last signed up for a CD, and these days you have to fight for every bit of yield you can find.
4. Set up CDs at different banks
Speaking of fighting for extra yield, consider setting up different CDs at different banks. The same bank may not have the most competitive rates at all points on the yield curve, so it might pay to have portions of your CD ladder at different institutions. Having accounts at multiple banks might seem like a nuisance, but CDs are passive enough investments that it should not be too much trouble.
5. Weigh early withdrawal penalty vs. reward
Your escape from a CD ladder might entail paying a penalty for early redemption, so always check out what those penalties are before you sign up. The milder the penalty, the less costly it would be for you to back out of a long term commitment should CD rates rise.
It takes a little work to set up a CD ladder, but once you invest that effort, you can sit back and let the ladder start working for you in return.
Comment: What is your experience with CD laddering?
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