Like savings and money market accounts, certificates of deposit (CDs) are relatively low-risk savings vehicles. But CDs offer higher interest rates because the balance cannot be withdrawn without incurring a penalty until the CDs mature. Using a strategy called “CD laddering,” you have regular access to funds and capitalize on better savings returns.
Banks may offer CDs with a wide range of maturity durations. However, the longer durations tend to offer the better CD rates — usually found with 5-year CDs. Not being able to touch your money for five years is a little daunting for many savers. This is where CD ladder proves useful.
Imagine CD laddering as a game of leapfrog (“CD leapfrogging” may have been a better name for this strategy).
Initially, you split up funds across CDs with durations that increase in fixed increments. Then, renew CDs for the longest duration.
For example, with $10,000, you can put $2,000 each into 1-, 2-, 3-, 4- and 5-year CDs. When each CD reaches maturity, you reinvest the funds into 5-year CDs. This approach means you can take advantage of higher CD rates without sacrificing access to cash (part of your funds becomes available on a yearly basis).
CD ladders can be customized for your individual financial habits and needs. You may prefer to set up a CD ladder so that funds become available semi-annually. Or, you can use shorter CD durations. Furthermore, don’t be afraid to cycle your funds into CDs at a different bank if the bank offers higher rates (though it will be more difficult to manage).
Other things to keep in mind are early-withdrawal penalties and CD-renewal terms.
In the event of an emergency, you can pull out the money from a CD but get hit with an early-withdrawal fee, which is usually equivalent to several months worth of interest earnings. Each CD may have its own early-withdrawal fee, so keep it in mind when choosing a CD.
Depending on the bank, renewal terms for CDs can vary — not understanding them may ruin your CD ladder. For example, you don’t want to automatically renew CDs that are less than 5 years. Or, you don’t want to renew a CD because you want to move that money to a CD at another bank that offers a higher rate.
Sure, the entire concept of CD laddering may involve a little more work but the financial incentive is enticing.