A certificate of deposit (CD) is one of the safest saving tools available and usually provides a higher return than a typical savings account does. The downside is that you do not have access to the funds until the CD matures (unless you want to incur a penalty).

With the highest rates found on CDs that last five years or longer, it would be best to build a CD portfolio with these long-term CDs to achieve the highest returns possible. The issue of liquidity has become a common concern as savers do not want their money tied up and unavailable in the case of an emergency. One solution to this problem is to create a CD ladder.

How a CD Ladder Works

Initially, you distribute your money between several CDs with sequential durations. For example, you could split $10,000 between a 1-year, 2-year, 3-year, 4-year, and 5-year CD ($2,000 per account). As the 1-year CD matures, you can reinvest that money into a 5-year CD, which would mature at the end of year six. As each CD matures, you reinvest your money into a 5-year CD, guaranteeing you will have access to some of your funds on a yearly basis.

CD Ladder Details

Initial investment:

  • 1-year CD at 2.00% APY
  • 2-year CD at 2.50% APY
  • 3-year CD at 3.00% APY
  • 4-year CD at 3.50% APY
  • 5-year CD at 4.00% APY

After each year:

  • A CD matures
  • Reinvest in a 5-year CD (usually offering the highest possible CD rate)

Starting at the end of year four, you should always have five 5-year CDs.

Why Should You Create a CD Ladder?

Because CD rates fluctuate daily and are subject to economic conditions, you can never be sure if a 5-year CD today would bring the same return as a 5-year CD opened next year. A CD ladder mimics the concepts of diversification and dollar-cost averaging in stocks. Employing this strategy will a) ensure higher returns compared to the saver who simply reinvests in 1-year CDs consecutively, and b) offer more liquidity compared to the saver who invests a lump sum in a single 5-year CD.

Tips For Building Your CD Ladder

• Shop around. You don’t have to stick with one financial institution to build your CD ladder. Just because a bank offers the highest 5-year CD rate doesn’t mean it offers the highest 1-year CD rate. But if you prefer to keep your accounts consolidated, stick to one or two institutions. Use this CD rate tool to compare CD rates.

• Negotiate your rates. It is often possible to negotiate a higher rate than what is listed. Banks have been known to offer a higher rate if another bank offers a competitive rate.

• Be aware of renewal terms. Find out the renewal process for your CDs. Some CDs will renew automatically after a grace period. Some will not. Be sure to not to renew anything other than 5-year CDs or it will disrupt your ladder. Also, a CD may renew at the old interest rate or at the current market rate. Of course, you want shop around for the highest rate available.

• Know the penalty for early withdrawal. Emergencies and other unavoidable situations will occur. Understanding the penalties of early withdrawal will prevent you from any costly surprises. You may want to steer away from CDs with harsh penalties.