Certificates of deposit (CDs) offer a simple trade-off: a higher interest rate than savings accounts in exchange for committing your money to the bank for a specified period. With the right strategy, such as through a CD ladder, you can make this trade-off work in your favor.
What is a CD ladder?
CD laddering is a technique using a series of CDs with different maturity dates - those maturity dates are spaced out over time like the steps on a ladder. This approach allows you to benefit from the higher yields associated with longer-term CDs while mitigating the potential disadvantages of locking your money up for a long CD term.
CD laddering can be applied in a variety of different ways, which you can adapt to your specific situation for saving and investing.
Why build a CD ladder
Long term CDs earn higher interest
Committing to a long term CD can allow you to get a higher interest rate than keeping your money immediately accessible in a savings account. Longer term CDs also earn greater interest than money market accounts.
FDIC insurance covers CD deposits
The Federal Deposit Insurance Corporation provides protection for deposits like CDs. Your CD accounts have FDIC insurance coverage in case a bank fails, giving you your money back. The FDIC insurance limit for deposits is $250,000 per deposit, per covered institution.
CDs are low-risk investments
CDs are popular among investors who aim to minimize investment risk. Compared to stocks, CDs have lower returns because of the current low interest rate environment, but they are less risky investments and require little effort for investors. Investors do not have to worry about following the stock market during its ups and downs if they choose CDs instead.
Disadvantages to a CD ladder
However, committing to CD accounts brings two potential disadvantages:
- The problem with liquidity. You do not have liquidity, or regular access to your money in case you need it
- May miss out on interest rate hikes. Because CDs lack liquidity, they limit your ability to switch to a higher-yielding products should interest rates rise
With CD laddering you do not lock into one CD for a specified term. Instead, you put money into a series of CDs with different maturity dates. This way, you have money becoming available at regular intervals, giving you a predictable schedule of liquidity to meet spending needs or to adapt to rising interest rates.
How to set up a basic CD ladder
So, suppose you have $10,000 you want to deposit. You could put it in a savings account, but unless you know you will need the money soon you could earn more on it in a CD. However, you might not want to commit it all to a 5-year CD, in case a need for money arises or interest rates increase and you want to reinvest some of the money. In that situation, you could use the money to create a CD ladder.
It is simple to put up a basic CD ladder. CDs are available in a variety of maturities, meaning that they last for different lengths from the time you sign up for them.
1. Determine how much to deposit
Decide the total to deposit into CD accounts for your ladder. Keep in mind that banks typically have minimum deposit requirements for CDs to earn the advertised annual percentage yield (APY). The minimum to earn APY may be as little as $1 and go up to $25,000 or more depending on the financial institution.
2. Decide on the CD term lengths
Money in your CD will automatically earn interest - but only if you avoid withdrawing from it before it matures. How long can you go without access to your money? As described above, there is a lack of liquidity with long term CDs so decide the range of your CD term lengths beforehand. In addition to term lengths, compare any early withdrawal penalties you may incur if you take out money from your CD before it matures.
Length of CD terms
- 1 month
- 2 months
- 3 months
- 6 months
- 9 months
- 1 year
- 1.5 years
- 2 years
- 2.5 years
- 3 years
- 4 years
- 5 years
3. Figure out how to divide your money for the ladder
If you spread the $10,000 between five different CDs in $2,000 increments, you could put your money into a 1-year, 2-year, 3-year, 4-year and a 5-year CD. This way you would have some liquidity on a yearly basis, and still have some of your money in higher-earning, long term CDs.
Example APYs for $10,000 CD ladder
Maximizing current yield for CDs
If you adjust this kind of ladder over time, you can squeeze even more yield out of it while still having liquidity on a yearly basis. Suppose you bought those five CDs at the beginning of 2016. When the 1-year CD came due at the end of that year, you could simply reinvest it in another 1-year CD, to come due at the end of 2017.
However, the original 2-year CD you invested in when first putting together your CD ladder would also be coming due at the end of 2017. Simply rolling the CDs over at their original maturities would cause this kind of duplication, meaning that your liquidity would no longer come at such regular intervals.
Rolling over CDs
Suppose instead at the end of 2016 you rolled that original 1-year CD into a 5-year CD. This would now come due one year after the original 5-year CD you had invested in at the beginning of 2016. Your original CD ladder would still have CDs coming due every year, so you could roll each of them into a 5-year CD as well.
Eventually, you would own a series of five 5-year CDs, each originated one year apart and thus each maturing one year after the other. Thus, you would have the yearly liquidity of the original CD ladder, but with all of your money at the higher yield of a 5-year CD.
Early withdrawal fees: How to avoid penalties
While a CD ladder can be an effective strategy to take advantage of high CD rates and various maturity dates, savers should be aware of fees associated with this deposit product. Carefully read the fine print of the terms and conditions of your agreement for your CD, including the maturity dates and early withdrawal penalties.
Penalties could mean losing interest earned
If you withdraw money from your CDs before the agreed upon maturity date, you may be subject to penalties like losing interest earned. Early withdrawal fees are more likely to be steeper for long term CDs compared to shorter term ones. Before considering CDs for a ladder, compare potential early withdrawal penalties and interest earned on CD rates. This will make it easier to know whether it would be worth it to have access to your money and withdraw early from your CD account or wait until it matures.
Find the best CD rates
Consider opening accounts at different banks
If you have had the same bank for a while, it's time to research more options for your ladder to get the best CD rates. According to the FDIC as of Nov. 6, 2016, the national rate for a 60 month or 5-year CD is 0.78 percent for deposits less than $100,000 and 0.80 percent for the same term CD for deposits $100,000 or greater.
However, there are institutions that offer much higher CD rates than the average rate. On the MoneyRates.com CD rates page, you can find bank rates with 2 percent or more APY for 5-year CDs for amounts $50,000 to more than $100,000.
What is a reverse CD ladder?
Unlike a basic CD ladder with CDs featuring various maturity dates, a reverse CD ladder involves CDs with the same maturity date that are purchased at different times. Some savers use the reverse CD ladder approach to save for a down payment for a house. This allows them to put money into a CD for a few years, earn money through high CD rates and then purchase another CD down the road to continue to grow their savings.
Refining your CD ladder
You can refine your CD ladder in a variety of ways. You can distribute your deposits more heavily to some maturity dates than others depending on when you anticipate having needs for the money. You can weight your money more heavily towards shorter term CDs if you think interest rates are likely to rise, or towards long term CD rates if you think rates are more likely to fall.
A CD ladder takes advantage of the higher yields offered by longer-term CDs, but by spacing maturity dates at regular intervals, it makes sure that you also have some degree of liquidity. They take a little effort to set up, but you may well find a CD ladder is worth the climb.