How To Build A CD Ladder

While most people consider tried-and-true investment products like a 401(k) plan or an IRA, there is another option that might be right for both short-term and long-term investments: the CD ladder. Here’s how and why you might want to consider using a CD ladder to build a solid investment strategy, rung by rung.

What Is A CD Ladder?

A certificate of deposit (CD) is an investment product. You invest a sum of money for a specific period of time in exchange for a fixed interest rate once the CD “matures.”

A CD ladder then is a strategy that involves investing an equal amount of money into separate CDs with various maturity dates. That allows you to take advantage of different rates of return without worrying about timing the rise and fall of interest rates, or the annual percentage yield (APY). APY tells you how much your investment earns, taking into account the effects of compound interest.

By regularly renewing CD accounts, you can benefit from the higher rates paid out by long-term CDs while having potential access to the funds in the short term.

Is A CD Ladder A Good Investment?

Like any investment strategy, a CD ladder has pros and cons, which you should consider in relation to your financial goals and budget. Always discuss financial strategies with a qualified advisor to ensure they are right for you. Here are some things to consider about a CD ladder

The Benefits Of A CD Ladder

A CD ladder can offer a variety of benefits, one of the most critical being the peace of mind that comes from lower risk, as with a CD you won’t ever lose your initial sum of money. It also frees you from worrying about fluctuations in interest rates because the series of CDs are designed to take advantage of the higher returns that come with a longer CD maturity data.

It also allows you to have more flexible access to your money, as the CDs will mature at different times. While ideally you will reinvest that sum of money into a new CD, you will be able to use that money as needed for a down payment on a house, an education expense, or another need that has a shorter time horizon than retirement. That liquidity brings its own peace of mind.

Because a CD is sold by a bank, it is an FDIC-insured product, just like your checking or savings account.

The Drawbacks Of A CD Ladder

However, that peace of mind comes with a catch – since the interest rate on a CD is fixed, you are locked into that amount even if the market rises more than expected. Risk and reward tend to go hand in hand when considering investment vehicles, and there are other options, like stocks, that are liable to have a higher rate of return, although that is by no means assured.

The payoff might be particularly low right now, given that we are currently in a relatively low-interest-rate environment, which, while appealing for mortgage rates, is not as beneficial for CD returns. And as inflation rises, CDs might not even keep pace with that. They also don’t come with the tax advantages that some other investment products such as 401(k) plans do, and you may have to pay early withdrawal penalties if you need the funds before the maturity date.

How To Set Up A CD Ladder

If the idea of low risk combined with a fixed return sounds appealing, a CD ladder might be for you. Here’s how it works.

1.   Open Separate Initial CDs

To build the rungs on your “ladder,” you’ll want to put money in CDs that have staggered maturity dates, typically from 1 – 5 years. If you had $5,000 to invest, the ladder would look like this:

• $1,000 in a 1-year CD
• $1,000 in a 2-year CD
• $1,000 in a 3-year CD
• $1,000 in a 4-year CD
• $1,000 in a 5-year CD

2.   Reinvest After Maturity Of Each CD

Each time your CD matures (starting with the one-year CD), you take that money and reinvest it in a five-year CD to keep building your ladder. So, now the ladder begins to look like this:

• $1,000 + 1 year of interest in a 5-year CD
• $1,000 + 2 years of interest in a 5-year CD
• $1,000 + 3 years of interest in a 5-year CD
• $1,000 + 4 years of interest in a 5-year CD
• $1,000 + 5 years of interest in a 5-year CD

If you follow the strategy, after 5 years, you will have five, 5-year CDs, one of which will then mature annually (and you can keep building that ladder, if you choose).

Of course, you may decide to break up the ladder as your investment goals change; for example, not reinvesting one of the year’s total amounts if you decide to use it to augment your down payment. Also CDs may automatically renew so make sure you know the status of all your investments and what you need to do, if anything, to reap the benefits of reinvesting.

Alternative CD Ladder Structures

There are ways to use the CD ladder structure that differ from the most common one described above. Here are two to consider:

Mini CD Ladder

Not sure you want to take the plunge with multiyear-long CDs? You can also choose to put your investment into CDs that have maturities dates of several months, rather than years. In this scenario, you’d have access to the funds every three months (or whatever term you choose). It’s important to realize that these short-term CDs typically pay even lower interest rates, but the tradeoff is that you can access your money quicker.

Uneven Splits

While the scenario described above recommended putting the same amount of money into each CD, this strategy entails putting different amounts in the CDs with various terms. You’ll want to make sure you have a good grasp on future interest rates to use this strategy to your best advantage as it’s a higher-risk option.

That means you’ll need to have a higher risk tolerance because it’s possible you could end up guessing “wrong” and putting less money in a higher-interest rate CD, or conversely more money into a lower-interest rate one, missing out on potential gains.

Remember that no one can time the market with certainty, so while an understanding of rate projection will make this strategy more liable to yield the returns you want, there is no foolproof way to know.

The Bottom Line

A CD can be a smart choice for investors who have a low tolerance for risk and want to ensure they are preserving and steadily growing their capital. By creating a CD ladder, you can enjoy the benefits that come with longer-term investments, without sacrificing liquidity.

As with any investment vehicle, it’s not right for everyone. It’s important to talk about your goals with a financial advisor before making any long-term financial decisions. They will help you explore the differences between saving vs investing so that will keep you on the path to financial wellness, ensuring you can reach the goals you have today along with a fruitful retirement.