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5 Moves to Optimize Your CD Ladder

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strategy-compassInterest rates have risen noticeably over the past year, creating a dilemma for CD shoppers:

Should you opt for the higher rate of a long-term CD or stick with short-term CDs so you can reinvest your money more frequently as rates rise?

Having the opportunity to reinvest your certificates of deposit sooner can help you capture the highest interest rates. But you don't need to settle for the lower yields of short-term CDs just to give yourself that opportunity. There's another way to ensure you can reinvest more frequently -- set up a CD ladder.

What is a CD ladder?

A CD ladder is a strategy that lets you earn a higher yield than you would with short-term CDs while creating more frequent liquidity than you would have with a long-term CD.

Rather than lock up all your money for a specified period of time in one certificate of deposit, you would own a series of CDs with different maturity dates instead. That way, you can benefit from high-yielding, long-term CDs while still having money become available at regular intervals. In its simplest form, for example, this would consist of spreading your money equally among 1-year, 2-year, 3-year, 4-year and 5-year CDs.

How a CD ladder works

What impact could this technique have on your investment strategy?

As of mid-April, 1-year CDs were yielding 0.66 percent, according to national averages compiled by the FDIC. At the same time, 5-year CDs were yielding 1.26 percent.

FDIC National CD-Rate Average - week of April 15, 2019:

Term1-year CD2-year CD3-year CD4-year CD5-year CD
FDIC National Average Rate0.66%0.84%0.98%1.08%1.26%

Obviously, you could earn a higher yield by putting all your money in a 5-year CD -- but suppose you had some financial needs in each of the next five years or you simply wanted to make sure you had money available at regular intervals for reinvestment in a rising rate environment. A CD ladder could give you the benefit of both: a higher yield than a 1-year CD and the flexibility of making some of your money available at 1-year intervals.

Given where rates were in the middle of April, if you had spread your money evenly among 1-year, 2-year, 3-year, 4-year and 5-year CDs, you would have had an average yield of 0.964 percent with one-fifth of your money becoming available at yearly intervals. Unless you have a greater near-term need for your money than that, this is more profitable than simply owning a 1-year CD at 0.66 percent. The table and chart below compare the results of the three different strategies:

Comparing CD Growth Strategies

Example: Suppose you have $50,000 to invest in a CD for 5 years - but you also want the opportunity to capture higher interest rates during that period. Here is a comparison of what you could earn in five years using three different strategies:

  1. One 5-year CD for $50,000
  2. A CD ladder - Five 1-year CDs for $10,000 each
  3. Five 1-year CDs for $50,000 each

(Using FDIC national CD rate averages for the week of April 15, 2019.)

TermOpening BalanceYear 1Year 2Year 3Year 4Year 5
One 5-year CD 1.26%$50,000$50,630.00$51,267.94$51,913.92$52,568.04$53,230.39
CD Ladder$50,000$50,482.00$50,968.87$51,460.64$51,957.36$52,459.09
Five 1-year CDs0.66%$50,000$50,330.00$50,662.18$50,996.55$51,333.13$51,671.93

chart

There is no rule that says all the money in a CD ladder has to be distributed evenly - so you can weight your investments in different CD lengths according to when your needs are planned to arise and what the prevailing rate environment is.

5 ways to optimize your CD ladder investments

If you want to provide opportunities to capture higher interest rates or simply access your money occasionally, a CD ladder can help you there. But here are five tips that can help you optimize your CD ladder even further, especially in an environment where interest rates are rising.

1. Plan your CD ladder for the long haul

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 structure 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 be reinvested into new long-term CDs, eventually you'll get to that ideal structure of having a series of long-term CDs maturing at regular intervals.

3. Look for sweet spots in yields

Certificates of deposit reward you with higher yields for longer commitments, but those rewards are not always spread regularly as you move out toward longer CDs. This makes some CD lengths relatively more attractive than others.

Currently, the average 5-year CD yields 60 basis points more than the average 1-year CD. This 60-basis-point added reward for the four-year difference in length implies that you get rewarded 15 basis points for each extra year. However, the smallest reward is only 10 basis points in difference between a 4-year and a 3-year CD yield, while the 18-basis-point reward for moving from a 4-year to a 5-year CD is unusually big. This implies that you might want to weight 4-year CDs less heavily than the other investments in your CD ladder.

4. Do some comparison-shopping

Understand that CD rates vary widely from bank to bank. While the average 5-year CD rate is just 1.26 percent, MoneyRates.com's CD rate-finder tool features several 5-year CDs yielding in excess of 3.0 percent. Rising interest rates over the past year have widened the differences between rates at different banks.

Shop around, and look at online banks to expand on your local choices. Nothing says that all the components of your CD ladder have to be at the same bank. In fact, spreading your ladder among different banks to get higher rates or better terms 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.

Rising rates have improved conditions for CD shoppers, and a well-constructed CD ladder can help you get the most out of this environment.

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