Interest rates are finally moving in the right direction for savers -- upward. If you invest in certificates of deposit, that movement prompts an important question: How do you balance the higher yields typically associated with long-term CDs against the opportunity to reinvest more frequently with short-term CDs?
Having the opportunity to reinvest your certificate of deposit becomes more critical when rates are rising because it allows you to capture higher rates sooner. But you don't have to settle for the lower yields of short-term CDs just to give yourself the opportunity to reinvest as rates rise. There's another way to ensure you can reinvest more frequently -- set up a CD ladder.
How a CD ladder works
What is a CD ladder? It is a series of CDs set up to mature at different times. Spreading your money out into different CDs this way allows you to benefit from a combination of long-term CD yields and short-term flexibility.
You can do this in a variety of ways. The image of a ladder suggests steps rising in equal increments. For example, you could construct a CD ladder of five CDs with maturity dates spaced one, two, three, four and five years from now. However, there is no rule that says you have to space the increments evenly or even put the same amount in each CD. Depending on your needs and prevailing conditions, you could choose to optimize your CD ladder by putting different spaces between the different maturity dates and/or putting more money in some CDs than in others.
5 moves to optimize your CD ladder strategy
According to national averages from the FDIC, as of mid-February 2018, 5-year CDs were yielding 0.91 percent while 1-year CDs were yielding just 0.07 percent. That would seem like a strong argument for favoring long-term CDs, but there is good reason to think CD rates may soon be rising. Inflation is heating up, and already mortgage rates and Treasury yields have moved sharply higher since the year began.
Should CD rates follow the rise in mortgage rates and Treasury yields, you might regret locking all your money into a long-term CD. Here are some ways you can hedge your bet by investing in a range from short- to long-term CDs, while optimizing your CD ladder for current conditions:
1. Think long term
Rather than a CD ladder consisting of a 1-year, a 2-year, a 3-year, a 4-year and a 5-year CD, the ideal would be to own a series of 5-year CDs each bought one year after the other. That way you would still have CDs becoming liquid at yearly intervals to meet your immediate needs or be available for reinvestment, but each of those CDs would earn a higher, long-term yield.
You could accomplish this by buying a 5-year CD now, and then a new 5-year CD one year from now and each year after that. This takes longer than buying a mix of short-term and long-term CDs right away, but it could be more rewarding.
2. Employ the leapfrog method
If you want to set up your CD ladder right away, you have no choice but to buy a mix of short-term and long-term CDs. However, as the short-term CDs mature, replace them with long-term CDs rather than new short-term CDs.
All the other CDs on your ladder will have moved one year closer to maturity anyway; so by having proceeds from your maturing short-term CDs leapfrog in length over your other CDs to buy a new long-term CD, eventually you will get to that ideal structure of having a series of long-term CDs maturing at regular intervals.
3. Look for sweet spots in yields
CDs reward you with higher yields for longer commitments, but those rewards are not always spread regularly as you move out toward longer CDs. Currently, the average 5-year CD yields 60 basis points more than the average 1-year CD. This extra 60 basis points for the four-year difference implies that you get rewarded 15 basis points for each extra year. However, the smallest reward is only 12 basis points for the difference between 4-year and 3-year yields, while the biggest reward is 18 basis points for moving from a 4-year to a 5-year CD. This implies you might want to weight 4-year CDs less heavily than the other investments in your CD ladder.
4. Do some comparison shopping
CD rates vary widely from bank to bank. While the average 5-year CD rate is just 0.91 percent, MoneyRates.com has found several CD products yielding in excess of 2 percent. With interest rates on the rise, look for the differences between banks to get even bigger.
Shop around, and look at online banks to expand your choices. All the components of your CD ladder don't have to be at the same bank. In fact, spreading your ladder among different banks to get higher rates might also help you stay under the $250,000 FDIC insurance limit.
5. Weigh rates against flexibility
While your primary focus should be on rates, also look at early withdrawal penalties when shopping for CDs. Finding high-yielding CDs with relatively mild penalties would give you a little extra flexibility which may come in handy in a rising rate environment.
A rising interest-rate environment would certainly be a change from the past several years. A well-constructed CD ladder could allow you to benefit from long-term rates now, with the possibility of earning even higher rates in the not-too-distant future.
Comment: What is your experience with CD laddering?
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