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How To Build A CD Ladder and Get The Highest Interest Rate

Published 10/21/08 (Modified 3/9/11)
By MoneyBlueBook

During tough times, there is always the inevitable flight to quality as investors seek out stable investment options to keep their money safe from loss. Oftentimes these safe investment choices include U.S. Treasury Bills, high interest savings, and money market accounts. However, those who want to shield their money from unnecessary risk during uncertain times but still maintain a very competitive rate of return ought to strongly consider certificate of deposits (CDs). Because CD's are issued by banks and credit unions, they enjoy the same iron clad FDIC insurance coverage and equivalent that checking accounts and saving deposits enjoy. When you buy a certificate of deposit through a bank and choose to invest your money in a CD, you can rest easy knowing that your money is fully protected up to the full FDIC coverage limit from unexpected loss (the current FDIC limit is $250,000).

While in the long run, investing in the stock market is the best way to earn high growth returns, sometimes the market conditions and wild price swings are too much to handle for some conservative short term investors. Especially for those you looking to preserve your capital and build up emergency fund savings within a short time frame, you may be more comfortable investing your money in a predictable interest bearing asset, like a high yield savings account or a CD. While I frequently solicit the use of safe investments for specialized purposes, I'm still an active bank interest rate chaser at heart - a person who constantly seeks out the best ways to maximize money and earn the most interest bang for one's buck. This desire to delicately balance protection against risk but at the same time still earn the highest interest rate is how I stumbled upon the use of CDs and CD ladders.

What Is A Certificate Of Deposit (CD) and How Do I Buy It?

A certificate of deposit, or a CD as it's most commonly called, is an interest bearing fixed time asset offered to consumers and businesses by banks and credit unions. When you buy a CD through a bank, you transfer money into the CD savings account for a fixed amount of time and agree not to withdraw the amount until the time period matures or expires. Upon maturation, you are free to pull your money out along with the accrued interest and decide whether you want to roll it over into another CD or walk away.

The available time periods for CD's vary from bank to bank, but usually they are offered for periods of 3 months, 6 months, 9 months, and so forth, up to as long as 5 years. However, some banks are extremely flexible and offer CD's for time periods as short as 1 month. While many banks require a minimum deposit to buy a fixed interest rate CD, some major banks have done away with minimum deposits, and customers are now free to buy a CD for as little as $5 (seems kind of silly to do that though). However, keep in mind that the best CD rates tend to be reserved for CD deposits that have very high minimums - called jumbo CDs, which usually require minimum balances in excess of $100,000.

Buying a CD is pretty straight forward - you can buy them commission-free from most banks and credit unions. For starters, you may want to check out your local credit unions or community banks for the best CD rates. Oftentimes, locally run institutions and online banks tend to offer higher rates for their CDs than more established brick and mortar brand name banks like Citibank, Bank of America, or JP Morgan Chase. Those who prefer online banking may want to consider buying their CDs through popular online banks like ING Direct. ING has been around for a while and has made setting up CD ladders incredibly easy. With just a few keystrokes, an ING Direct CD ladder can be set up simply by selecting the monetary amounts and time periods desired.

Deciding when to purchase and which time period to pursue requires a bit more planning. While market prices and interest rates can never be fully timed with any real precision, there are still generally applicable rules of thumb when pursuing a CD purchasing strategy. If it's your determination that bank interest rates are very high and appears to be overinflated (prepped to drop in the near future), then it's in your best interest to purchase a CD through your bank and lock in that high interest rate today for as long as possible. On the flip side, if it's your current estimation that interest rates are rather low and undervalued (prepped to rise in the near future), you'll want to be more cautious in locking up your money for extended periods of time. You don't want to lock up your money in a multi-year CD for something like 3.5% annual percentage yield (APY) and later have to watch helplessly as interest rates soar to 4.5%, and not be able to pursue the higher rates until the CD matures.

Why Buy Or Invest Money In A CD? Why Not Just Keep My Money In A High Yield Savings Account?

As we all know, banks make money by taking our bank deposits and loaning the money out to other consumers and businesses for profit. In return, the bank offers checking and savings account holders an interest rate as compensation for allowing the bank to use their money as loans for other people. Banks love the concept of CDs because it allows them to maintain a more stable and higher balance of cash on hand to loan to others. In return for your agreement not to touch the CD money for the agreed upon period of time, the bank is willing to provide you a higher interest rate for your CD deposit than that offered to traditional checking and savings account deposits. The higher interest rate is to compensate you for the loss of liquidity, which pertains to your ability to utilize your monetary assets as you wish.

In general, the longer you agree not to touch the CD deposit, the higher the rate of return the bank will offer you. Thus, the interest rate offered by your bank for a 5 year CD will almost definitely be much higher than that for a mere 3 month CD deposit. This is the reason why savvy savers, who are not in immediate need of cash, should not merely keep all of their money stashed away in checking or savings accounts. In almost all cases, CDs offer APY interest rates that are frequently 1 to 2 percentage points higher than the best best high yield savings accounts. For example, currently as of the date of this writing - ING Direct is offering 3.00% APY for their popular high interest Orange savings account (a very good savings rate at this time). However in comparison - their 6 month CDs currently have yields of 3.50% APY, their 12 month CD's have yields of 4.00% APY, and their 24 month CD's have high interest yields of 4.25%. CDs simply blow savings accounts away in the interest rate department.

Choosing between interest rate and loss of liquidity (length of duration) is the most important decision when purchasing CD's. The more liquidity and control of your money you agree to give up, the higher the interest rate you get back in return. In the banking world, checking accounts are the most liquid of accounts as there are usually little restrictions placed on them by banks. But as a result, checking accounts routinely earn the lowest interest income, if any at all for the account holder. Lower on the liquidity scale are high yield savings accounts, which offer more attractive interest rates for deposits. However, savings accounts are constrained by the monthly 6 ACH transfer limitation. At the lowest rung of the liquidity scale are CD's which generally offer the most attractive interest rates compared to the other two. However, they are frequently the most constrained as the funds must remain off limits until they mature.

The biggest drawback of CDs is the penalty fee you must fork over if you commit an early withdraw. Once you buy a particular CD for a fixed time period, if you withdraw the money or cash out for any reason including a personal financial emergency, you will incur a significant financial penalty - which will likely wipe out any interest income accrued, as well as cut into the principle used to fund the CD in some cases. Because there are rarely exceptions for waiving the withdrawal penalty, you must make sure you are fully comfortable and committed with having that amount of money locked up in a CD account for the agreed upon period of time before making the plunge.

Building A CD Ladder Is A Good Way To Maximize Your APY Interest Rate and Minimize Liquidity Worries

A CD ladder is simply an investment strategy used to manage CD's that maximizes liquidity and the rate of return, while minimizing the risk and the drawbacks of locking up your investment money for an extended period of time. Laddering CDs require the account holder to initially purchase multiple CD's with different intervals so that they ultimately mature at fixed regular intervals. By staggering multiple CD investments so that each individual CD matures at set intervals, this gives the deposit holder additional liquidity and control of the otherwise frozen money so that he or she can take advantage of rising interest rates, and still be able to chase the highest rates possible. Similar to dollar cost averaging for stock investments, CD ladders are great investment vehicles for those who want the flexibility to pursue better opportunities as they arise, but still want to maintain a predictable cash flow.

Below are two examples of how you may want to create your CD ladder system. As each individual CD investment matures you should seriously consider reinvesting in a new CD account with a term that's equal to the longest term CD. Purchasing multiple certificate of deposits with different maturity dates enables you to take advantage of higher interest rates normally associated with longer term CDs while still ensuring frequent access to large portions of your money. By staggering your CD investments across several rungs of this CD ladder, you generally can increase the potential earnings of your CD portfolio, but still maintain some semblance of liquidity and control of your money along with the security of knowing that your money will become fully available within a relatively short time frame. Of course, should you decide to, you can always make the decision to halt the CD laddering process at the end of each individual cycle and eventually free up all of your money:

CD Ladder Example 1 - Money Is Freed Up Every 6 Months

This set up is suited for individuals comfortable with having their money locked up for 6 months or longer and looking to earn a higher rate of return in exchange. Let's say you wanted to create a CD ladder system that frees up money every 6 months. Here is how you may want to set it up. This arrangement requires an initial one time start up CD funding of $4,000 and will last for 2 years. As always, you are free to play around with the numbers to suit your purpose and savings goals, but this should give you a general idea as to the mathematics behind CD laddering:

  • Put $1,000 in a 6 month CD
  • Put $1,000 in a 12 month CD
  • Put $1,000 in a 18 month CD
  • Put $1,000 in a 24 month CD

After you have established a CD ladder with 6 month, 12 month, 18 month and 24 month terms, when the first 6 month CD matures, you would invest the funds in a new 24 month CD. Similarly with the passage of time, when the next 12 month CD matures, you would invest the funds of that particular CD in another new 24 month CD, and continue the process for the 18 month and 24 month CDs as each subsequent CD expires. At the end of two years you'll have four individual 24 month CDs with a new $1,000 CD maturing every six months.

CD Ladder Example 2 - Money Is Freed Up Every 3 Months

This set up is more suited for individuals with greater liquidity concerns. If you're worried about locking up your money for periods of 6 months or more, 3 months may be more appropriate for you. Let's say you wanted to create a CD ladder system that frees up money every 3 months. Here is how you may want to set it up. This arrangement requires an initial one time start up CD funding of $4,000 and will last for 2 years:

  • Put $500 in a 3 month CD
  • Put $500 in a 6 month CD
  • Put $500 in a 9 month CD
  • Put $500 in a 12 month CD
  • Put $500 in a 15 month CD
  • Put $500 in a 18 month CD
  • Put $500 in a 21 month CD
  • Put $500 in a 24 month CD

After you have you have established a CD ladder with 3 month, 6 month, 9 month and 12 month terms, 15 month, 18 month, 21 month and 24 month terms, when the first 3 month CD matures, you would invest the funds in a new 24 month CD. Similarly with the passage of time, when the next 6 month CD matures, you would invest the funds of that particular CD in another new 24 month CD, and continue the process down the line as each subsequent CD expires. At the end of two years you'll have eight individual 24 month CDs with a new $500 CD maturing every 3 months, plus interest.

I know it seems quite complicated, but it really is not. By staggering your CDs through this CD ladder system, you'll be able to ensure you always have money freeing up every fixed interval period, whether it's every 3 months, 6 months, or even as short as a matter of a month depending on how you set it up. This allows you to use your CD deposits for emergency fund purposes if you ever need it and may even help promote a healthy and active savings habit, allowing you to meet your financial goals.

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