CD Ladder Strategy: Explanation, Pros & Cons
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Summary:
CD laddering is a safe and effective way to save money and earn higher interest rates than a standard saving account. The strategy involves layering CDs that expire at different but regular intervals (i.e., annually). While this strategy helps to create increased liquidity and flexibility, there are some drawbacks to CD ladders. These include early withdrawal fees, low-interest rates (compared to riskier investments like stocks and bonds), and interest rate risk.
If you’re looking for an investment option that produces steady returns, you may have run into certificates of deposit (CD). These investments are one of the safest options, as they earn a fixed interest rate over a specified period of time. After your CDs mature, you receive your original investment funds plus interest. While this is a safe way to earn a couple bucks, there’s another way to earn even more from your CDs.
When employed in a strategy called a CD ladder, CDs can provide regular, predictable, and guaranteed returns. When shorter-term CDs mature, you use the returned principal and interest to purchase longer-term CDs that match the original length of the ladder. (So if you have a five-year CD ladder, you would buy another five-year CD). This helps to maximize the interest rates of the CDs since, typically, longer-term CDs have higher interest rates than shorter terms.
While this can be a great strategy for some investors, there are some downsides that come with CD laddering. In this article, we’ll take a deep dive into what a CD ladder is, the pros and cons of this method, and whether this investment strategy is the right path for you.
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What is a CD ladder?
A CD ladder is an investment strategy that utilizes certificates of deposit by staggering their terms or maturity dates, which creates regular cash flow for the investor. To build a CD ladder, an investor would buy multiple CDs of different maturity dates, like a one-, two-, three-, four-, and five-year CD. At the end of the first year, the investor would receive the principal of the one-year CD, plus the interest paid on the other CDs.
From there, the investor could use the returned principal and interest when the shorter-term CD matures each year to buy another CD. Depending on the length of your ladder, you may want to buy something longer, like a four-year CD, or something more short-term, like a two-year CD. This continues growing the ladder and provides a regular stream of income from maturing CDs. The result after a few years of this strategy is a series of CDs maturing at regular intervals.
Pro Tip
Before investing in a CD, make sure you look at the minimum deposit requirements. Depending on the CD you’re interested in, some financial institutions require a larger minimum deposit for their CDs than others.
What type of CD should you use for a CD ladder?
Traditional CDs work great because of the liquidity and flexibility features of a CD ladder. Many brokerage firms offer services to build CD ladders for their clients, which can be beneficial if you are careful to consider commissions and fees.
It would be best to avoid no-penalty CDs since they pay lower rates than traditional CDs, and the strategy allows for the return of principal regularly throughout the term. It would also be best to avoid callable CDs as one of the longer-term CDs could be called early, leaving the ladder without one of its rungs. If this happens, you may need to replace the called CD with one that has a lower interest rate.
If you need some additional advice on building your CD ladder, you may want to reach out to one of the investment advisors below.
How long should a CD ladder be?
The length of your CD ladder should align with your time horizon, particularly if there is a short-term goal like having a down payment for a house in four years. In that case, the length of your CD ladder should be four years.
Another way to define the length would be to figure out how much of your principal you want returned to you each year. To do this, divide the total amount of money you want to put into the ladder by the amount of principal you want back each year. For example, if you have $20,000 to invest, and would like $4,000 in principal returned each year, then you should plan to build a CD ladder over five-year terms.
IMPORTANT! You can also use shorter-term CDs to build a mini CD ladder. Instead of buying a CD maturing in three or five years, purchase CDs with a term of three, six, and nine months. Just remember that shorter-term CDs tend to have lower interest rates, so your returns may be lower with a mini CD ladder.
Pros and cons of a CD ladder
Though CDs are generally safe investments, you should always consider both the pros and cons of an investment before deciding on one.
Pros of CD laddering
Predictable
A CD ladder creates a predictable cash flow for the investor. By design, there is interest paid and principal returned to the investor at defined intervals chosen by the investor.
This could be advantageous for a retiree as it is easy to plan spending and expenses if the incoming cash flow is known. This can help reduce their financial stress in retirement.
Guaranteed
CDs in banks are guaranteed by the Federal Deposit Insurance Corporation (FDIC) — or the National Credit Union Administration (NCUA) for credit unions — to return the principal and interest at maturity.
This FDIC insurance protects up to $250,000, which is much more than most people will receive from a CD. This makes CDs a safe investment with a guaranteed return. Coupled with the predictability of the ladder strategy, this makes CDs quite attractive for the conservative investor.
Interest rates
Though the annual percentage yield (APY) on a CD is lower than the returns from stocks, CDs carry less risk and often pay a substantially higher interest rate than a traditional savings account or money market account. Long-term CDs will also have even higher interest rates that can help maximize the interest payments you receive.
That being said, you can have both a CD ladder and a money market account to continue improving your savings. To find the best money market account for your money, take a look at some of the accounts below.
More liquidity
While CDs are less liquid than a traditional savings account, using a CD ladder provides more liquidity than a long-term CD with the same maturity schedule. That’s because the ladder strategy returns a portion of the principal to you regularly before the end of the term.
If you only purchased a five-year CD, you may get interest payments annually, but the principal will remain in the CD and may not be withdrawn without a fee.
Flexibility
When compared to buying a similar-length CD, utilizing a CD ladder offers the investor flexibility and choices. The strategy requires multiple CDs, which you can purchase from multiple financial institutions. You can even purchase different types of CDs for your ladder. This provides you flexibility in designing a strategy that fits your goals and objectives.
Cons of CD laddering
Early withdrawal penalties
Many CDs have an early withdrawal penalty or fee. So if an investor needs cash before the maturity date, or more cash than the expiring CD returns upon maturity, those additional withdrawals may be subject to an early withdrawal fee.
The amount of the fee varies by institution and CD, but you can expect a minimum of $25 or the equivalent of three months’ interest.
Interest rates
Though CDs comparatively pay a higher interest rate than savings accounts and money market accounts, they often pay lower than bonds and earn less than investing in the stock market. This is primarily a function of risk.
So if your goals require a higher interest rate than what a CD ladder can provide, you’ll need a different strategy. As with all financial products, they are only as good as how they align with your goals and risk tolerance.
Falling interest rate environment
Another issue that CD ladders often face is how they work in a falling interest rate environment. This is particularly true when the investor continually rolls the expiring CDs into new CDs to continue the ladder strategy indefinitely.
When discussing falling interest rates, consider a five-year CD ladder. If at the end of the first year a new five-year CD pays a lower interest rate than the original five-year, the strategy will start to produce less cash flow.
If the falling interest rates continue (like what happened during the Great Recession), this effect will compound and start to erode the interest earned with this strategy. For example, the table below shows a five-year CD ladder where the rates on the five-year CD in years six and seven are falling.
| Year | 1 | 2 | 3 | 4 | 5 | 6 | 7 |
|---|---|---|---|---|---|---|---|
| CD term | 1-year | 2-year | 3-year | 4-year | 5-year | 5-year | 5-year |
| Interest rate | 3% | 3.50% | 4% | 4.25% | 5% | 4.50% | 4% |
Who should use a CD ladder?
A CD ladder would be beneficial for the conservative investor who has a regular need for cash flow but doesn’t want to lock up all their funds in a long-term CD. For example, someone late in retirement who needs regular income with little to no downside risk may find CD ladders to be a helpful investment strategy.
It could also be useful to an investor who wants to stash some money away for a short-term goal like a down payment on a house. This savings strategy will provide additional returns over their savings account with no downside risk.
IMPORTANT! If you’re thinking about building a CD ladder, check to see if your financial institution has a CD ladder calculator. This could help you see how much money you’ll actually earn through this investment strategy.
Key Takeaways
- A CD ladder is an investment strategy that produces regular returns by stacking CD maturity rates. Your CD terms can vary in years or months.
- You can build a CD ladder by purchasing several CDs with different terms. For instance, instead of buying one three-year CD, you can buy a one-year, two-year, and three-year CD. Once the one-year CD matures, you purchase another three-year CD to keep the ladder going.
- CD ladders are safe investments with guaranteed protection and plenty of flexibility for new investors or those close to retirement.
- However, CD ladders also charge early withdrawal penalties and don’t provide returns as high as bonds or stocks.
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Chip Stapleton is a Series 7 and Series 66 license holder, CFA Level II candidate, and holds a Life, Accident, and Health Insurance License in Indiana. Chip received his Bachelor's in Saxophone and Physics from the Indiana University Jacobs School of Music in 2008. During his time there, he honed his mathematical and analytical skills. He received his Master's in Music Technology from Indiana University Purdue University—Indianapolis in 2010, where he was a Graduate Assistant. He is a financial advisor who enjoys the opportunity to train, develop, and support new advisors to build their own practices and help their clients achieve their goals. This included helping with case design, product knowledge, investment analysis, investment recommendation, portfolio construction, asset management, financial statement analysis, business planning, and business exit strategies.
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