What comes to mind when you hear the term “CD Ladder”? If it is a leaning tower of compact discs then you’re probably at least as old as I am. But I’m not talking about music storage choices – I’m talking about Certificates of Deposit.
A certificate of deposit, also known as a CD, is a type of savings instrument offered by banks and credit unions. With a traditional CD you make an agreement with a bank to leave an amount of money on deposit at that bank and in exchange the bank offers you a higher interest rate on your deposit. The agreement and interest rate is set for a fixed about time – typically 6, 12, 18, 24, or 36 months, although longer terms and other irregular term lengths may be available at your particular financial institution.
So, you may be asking yourself why not just keep all my savings in my checking account or in a savings account? Well, the short answer is simple: higher interest. Most standard checking accounts don’t offer interest and even interest bearing checking accounts rarely provide more than a modicum of interest. Interest rates on savings accounts vary widely from institution to institution, but even a bank that offers a high yield savings account will offer CD rates above their current savings account rates – after all that’s their main hook. And if the CD rates at a particular bank don’t line up with what you’re looking for, just keep looking. Online tools like BankRate.com can speed up your search and help you find the best option.
One more benefit of putting some of your savings into a CD is the protection from falling interest rates. My personal CD Ladder has certificates of deposit earning 2.5% despite the plummet interest rates have taken since COVID-19 pandemic began.
The biggest downside of using a certificate of deposit is the risk of needing the money and having it tied up. This is why I don’t recommend putting your entire emergency fund into CDs. The good news is you can still get at the money in the CD. The catch is you have to pay a withdrawal penalty – usually 3 months interest. Some financial institutions are rolling out a new “Liquid CD” that removes the withdrawal penalty, as long as you meet certain requirements.
Certificates of deposit have another potential downside – a minimum required deposit. Sometimes this can be as little as $50, but often is $500, $1000, or more depending on the bank. Some online banks like CapitalOne and Ally don’t have a minimum, so the CD you open can be tailored your specific situation.
The flip-side of the interest rate protection discussed above is the risk of interest rates going up while you’re locked into a CD with a lower rate. This risk is smaller than you might think, since interest rates on savings accounts tend to move up slowly. Plus, when you open your CD it will already have a higher interest rate than your savings account. Additionally, some banks have some options to boost your CD rate after you open your account. The first is a “Rate Guarantee” that will boost your CD rate if interest rates go up shortly after you open your CD. The second is a “Bump Up CD” that allows you to choose to increase the rate on your CD sometime during the term if you see that rates have gone up.
You can take advantage of these special features if they’re available on CDs where you bank. This will allow you to still further mitigate the interest rate risk and the chance of a withdrawal penalty when making a CD Ladder.
How to make a CD Ladder
CD Ladders are a set of CDs you initially open with varying terms, and then as the shortest term matures, you renew it at the longest term. For instance, you might have $1500 set aside beyond your emergency fund. You could break it into three chunks of $500 dollars each and open three CDs – one each at 6, 12, and 18 months. Once the 6-month CD matures, you can roll it into a new 18-month CD. When the 12-month matures, you’ll do the same. In this way, you’ll never be more than 6 months from an extra $500, should you need it for something. Since longer terms have higher interest rates, you’ll also always be maximizing your return once your CD Ladder gets started.
The 6, 12, 18-month ladder isn’t the only choice, however. You can customize the CD Ladder to whatever suits you. If you want to keep the spacing a little closer together, you could start with a 3 month term and add in a 6, 9, 12, 15, and 18 month term. If your horizon is a little further out you could start with a 12 month term as the bottom rung on the ladder and add in rungs at 2, 3, 4, and 5 years.
The ladders described so far can typically be opened all at once. However, if you have the patience for it, there’s another CD Ladder you can try. Take the money you’re thinking about putting in CDs and make a small 3, 6, 12 month ladder each month until you have a CD maturing and renewing each month of the year. This is one of my personal favorite approaches to a CD Ladder, because a portion of the money is always available within 30 days.
So, will a CD Ladder help boost the returns on your savings? It very well might, but you’ll have to decide if it fits in with your financial goals. Let me know in the comments below if a CD Ladder could work for you and be sure to mention your favorite ladder or any questions you have on getting started.