How Does a CD Ladder Work?
Key Takeaways
- A CD ladder is a method to maximize savings by spreading funds across several CDs of varying terms.
- CD ladders can help you earn more interest on your savings than if you use a traditional savings account or just one CD.
- Monitoring the maturity dates of each CD is important in order to avoid early withdrawal fees and automatic renewals.
When building savings, some Americans use a ladder – a CD ladder, that is.
A certificate of deposit allows you to deposit money into an interest-bearing account and lock in an interest rate for a set period, normally three months to five years. For those seeking a safe way to earn a potentially high interest rate for their money, consider a CD ladder.
What Is a CD Ladder?
“Like bell bottom pants, CDs are making a comeback in the investment world,” says Steve Azoury, owner of investment services firm Azoury Financial in Troy, Michigan. “After years of low returns, banks are trying to secure accounts with teaser rates, good for short periods of time, hoping customers will forget that the renewal rates are very low.”
When you put together a CD ladder, you maintain several short-term and long-term CDs at the same time. This lets you nail down attractive annual percentage yields across a variety of CDs while freeing up cash to withdraw or reinvest as each CD matures and its term ends. You may be able to earn more interest with this strategy than if you place all your money in one CD.
The CD ladder can also help you avoid early withdrawal penalties if you need to access some of your cash. If all your CD savings sit in just one account, you run the risk of paying an early withdrawal penalty if you need to take out money before the CD has matured. Instead, a CD ladder periodically frees up cash due to the staggered terms.
How to Build a CD Ladder
Buying a CD typically includes an evaluation of trade-offs. A longer-term CD commonly will offer a higher APY, but then you’ll be locking your money up for a longer period of time. A successful ladder helps you get around that trade-off. Here are three steps to take when you’re building a CD ladder.
1. Figure Out How Much Money to Invest
Before anything else, decide how much money you want to commit to your CD ladder, says Krisstin Petersmarck, president and founder of New Horizon Retirement Solutions based in Bloomfield Hills, Michigan.
Some CDs require a minimum deposit, typically $500 or $1,000, but sometimes higher. Others require no minimum deposit. Generally, you can’t add money to a CD once you’ve made the initial deposit.
CDs are insured for up to $250,000 if they’re held at a federally insured bank or credit union.
2. Determine How Many CDs to Open
Let’s say you’ve settled on investing a total of $5,000, and you’d like to evenly split the money among four CDs. You also want to be able to access your money every six months. Here’s an example of how that might work.
- $1,250 in a six-month CD with a 1% APY
- $1,250 in a 12-month CD with a 2.6% APY
- $1,250 in an 18-month CD with a 3.5% APY
- $1,250 in a two-year CD with a 4.3% APY
After the six-month term has ended, you can roll that CD into a new two-year CD with a higher APY. In another six months the 12-month CD also gets re-invested into a two-year CD. Pretty soon you’ll have four two-year CDs with terms ending six months from each other.
Petersmarck points out that you don’t need to keep an equal amount of money in each CD that makes up the ladder, and you don’t need to maintain every CD at one financial institution. This freedom lets you secure the best CD rates among various banks, credit unions and other financial institutions.
3. Choose the Financial Institutions Where You’ll Open the CDs
Of course, the APYs that a financial institution offers for CDs will help drive your decision about where to park your CDs. But you also should consider factors such as the financial institution’s menu of CDs, early withdrawal penalties, reputation, customer service and online capabilities.
Be sure to check out credit unions and online banks, which often provide some of the best CD rates.
What Is a Mini CD Ladder?
A mini CD ladder consists of only short-term CDs. For example, you might open a three-month, six-month and nine-month CD, and then reinvest the money in a nine-month CD as the term for each expires. This strategy can give you easier penalty-free access to cash than longer-term CDs.
Use this free savings calculator to project how your money can grow over time.
CD Ladder Benefits
Benefits of a CD ladder include:
- Periodic access to cash without early withdrawal penalty fees thanks to staggered CD terms
- Potentially higher interest rates than regular checking or savings accounts
- Potential to earn more interest than if all your money was deposited in one CD
CD Ladder Drawbacks
Drawbacks of a CD ladder include:
- Falling interest rates may water down the ladder strategy as CD terms expire. “CD ladders may backfire if rates are lower in the future,” Azoury says. You may have been able to find a better rate elsewhere without the laddering.
- APYs for CDs generally lag the inflation rate, so your CD’s value may not have as much purchasing power upon maturation.
- Possibility of early withdrawal penalties. “The biggest drawback to CD ladders is liquidity. You risk that you may need the money before the CD matures, and you will pay penalty fees to access it,” Azoury says.
- Monitoring CD maturity dates and reinvesting money requires a hand-on approach. If you intend to withdraw funds, but miss a maturity date, the CD will automatically renew.
CD Ladder Alternatives
If the CD ladder strategy isn’t right for you, here are some alternatives to earn money on your savings:
- No-penalty CD. This type of CD allows penalty-free withdrawals before the term ends.
- Bump-up CD. This type of CD lets you raise, or bump up, the interest rate before the term expires. A bump-up is typically a one-time option.
- Step-up CD. This type of CD automatically increases the interest rate at predetermined intervals during your account’s term.
- High-yield savings accounts. These accounts pay higher-than-average interest rates than traditional savings accounts.
- Bonds. Corporations and governments issue bonds to raise money in exchange for periodic interest payments.
- Dividend stocks. These stocks share corporate profits with shareholders in the form of cash or stock.
- Money market funds. A money market fund is a type of mutual fund that invests in low-risk debt securities.
- Fixed annuity. A fixed annuity, a type of insurance contract, locks in a certain rate of return and provides a steady source of income in retirement.
