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Certificate of Deposits (CDs) are some of the highest-yielding deposit accounts offered at most banks and credit unions. But, they come with a catch: your money is locked away for a certain period of time, and generally you can’t unlock it without paying an early withdrawal penalty.
It’s also no secret that interest rates are changing these days. That can also affect the returns you get from saving with CDs.Things only get more complex if you’re attempting to create what is called a CD Ladder, which can be used to take advantage of higher APYs while staggering investments so all your cash isn’t tied up for a very long time.
If you want to save money by creating your own CD ladder, you need to juggle your own financial goals with shifting interest rates and early withdrawal penalties. It’s possible that CDs may not even be the right investment tool for you. How are you supposed to decipher what’s the best course of action when there are so many competing possibilities? Fear not. We’ll help you decide whether CD ladders are the right investment tool for you and how to get the most out of them in this guide.
In this guide, we’ll cover
What is a CD ladder?
A CD ladder is a series of several CDs that are structured with varying terms. By staggering the terms, you ensure that each CD finishes its term at regular, predictable intervals. That way, you’ve got access to a steady stream of cash while still earning higher rates than you might through a regular savings or checking account.
The main disadvantage of CD ladders is that your money is locked away for a certain length of time. This differs for each CD and is called its term. CD terms can range all the way from one month to ten years. Generally, the longer the CD term, the higher the interest rate you can get.
Logically, you’d think that the best thing to do would be to put all your money in long-term CDs, right? Unfortunately, doing so has two specific risks.
You could miss out on rising rates. If the Federal Reserve raises interest rates (as they have been doing for the past two years), many banks and credit unions soon follow by raising the rates on their own deposit accounts. But, if you’re locked into a long-term CD, you could be stuck in a high-interest rate environment with the poor interest rates from yesteryear. That means you won’t be earning the maximum amount of interest possible.
It’ll be hard to tap into your savings in a pinch. Secondly, what if something happens and you need access to that cash? Can you predict what’ll happen in five years—a home purchase, major medical bills, or some other unexpected large expense? If your money is locked away in long-term CDs, you could be out of luck unless you pay a potentially-substantial early withdrawal penalty.
Luckily, there’s an easy solution that lessens these two risks: a CD ladder.
How to create a CD ladder in 3 easy steps
A CD ladder is a pretty intricate strategy. You split your money up into equal parts and match each pot of cash to a partnering CD. Then, you line them all up in a precise order and wait for the interest to accumulate.
Sound confusing? Let’s break it down with an example to show you exactly how it works with a basic five-year, five-CD ladder.
To start, let’s assume that you have $5,000 that you want to invest in a CD ladder (although this will work with any amount of money).
Step 1: Open up five separate CDs
Divide your cash into five equal parts. What we’re going to do is open five separate CDs. So, divide your cash into five equal pots of $1,000 each.
Search and compare to find banks with the best rates on CDs. Go to your bank of choice, either in-person or online. It’s possible to open up accounts at different banks or credit unions if they offer better rates on some CDs, but keep in mind that that will increase the complexity of this strategy. Open up five separate CDs with each pot of cash all at once and on a staggered schedule. Here’s what you’ll have when you leave the bank:
- $1,000 in a one-year CD
- $1,000 in a two-year CD
- $1,000 in a three-year CD
- $1,000 in a four-year CD
- $1,000 in a five-year CD
Mark the date that you open all of these CDs on your calendar so that you can keep up with the CDs’ maturity dates.
Step 2: Each year when a new one-year CD matures, renew it ….and convert it into a five-year CD
Every year on your CD maturity date, one of your CDs’ terms will be up. For example, if you open a CD on May 26, 2018, then your one-year CD will come due on May 26, 2019. Your two-year CD will come due on May 26, 2020, and so on.
With most banks, when a CD becomes due, it will automatically roll over into another CD of the same term length (a one-year CD will automatically roll over into another one-year CD when it matures, for example). After it automatically rolls over, you will have a grace period of around one to two weeks where you can withdraw the money, add more money, and/or change the CD to a different term length — penalty-free.
Instead of letting your CD roll over into another one-year CD, you’re going to want to switch it up. Before the grace period ends, you’ll want to renew it into a five-year CD instead. Then, in 2020, you’ll do the same thing: you’ll renew the now-mature two-year CD into a five-year CD, and so on.
If you open up all of your CDs in 2018, it’ll look like this:
- 2019: renew the one-year CD into a five-year CD
- 2020: renew the two-year CD into a five-year CD
- 2021: renew the three-year CD into a five-year CD
- 2022: renew the four-year CD into a five-year CD
- 2023: renew the five-year CD into another five-year CD
The reason we do this is because the five-year CDs pay out vastly higher rates of interest than the shorter-term CDs. If you can keep all of your money in the highest-earning CDs, you’ll get the maximum amount of cash possible.
Step 3: Decide whether you need to pull the money out or not
The other reason we do this strategy is because if we need to withdraw the money, we get free access to one new CD per year on our CD maturity date. In our example, that means you can withdraw $1,000 (plus whatever interest the CD earned) once per year without paying an early-withdrawal penalty.
Each time a CD becomes due, you should ask yourself: Do I need to withdraw this cash for any reason? If the answer is no, then keep your money in a CD ladder. If it’s not already invested into a five-year CD, then go ahead and renew it into a five-year CD. If it already is invested into a five-year CD, then just let it auto-rollover into another five-year CD. As long as you don’t want to withdraw the cash, your CD ladder will be fully on autopilot from this point forward.
Mini CD ladders: Explained
The five-year CD ladder sounds great, but if you’re like a lot of other people, you might need more frequent access to your money than once per year. That’s where a mini CD ladder might come in handy.
Rather than setting it up so that a new CD becomes due once per year, you can choose shorter term CDs and stagger them so that they mature every few months instead.
Let’s look at another example—the three-month, four-CD ladder.
You would divide your cash into four equal pools and open up four new CDs with these terms:
- Three-month CD
- Six-month CD
- Nine-month CD
- Twelve-month CD
One new CD will become due every three months. When it does, you would renew it as a 12-month CD with a higher rate. That way, you can access your money once every three months instead of once every year.
If you want even more frequent access to your money, it might be possible to restructure this in a different way. Some banks have one-month CDs, although they’re not as common as three-month CDs. If you open 12 one-month CDs and renew each of them into 12-month CDs, then you could even get access to your cash every single month instead of every three months. The downside of the mini CD ladder is that you won’t earn as much, because five-year CDs carry better rates than a twelve-month CD.