CD Ladder

What Is a CD Ladder?

A CD ladder is a strategy in which an investor divides a sum of money into equal amounts and invests them in certificates of deposit (CDs) with different maturity dates. This strategy decreases both interest rate and reinvestment risks.

A CD is an investment product that offers a fixed interest rate for a specified period of time. The invested funds, which are insured up to $250,000 by the Federal Deposit Insurance Corporation (FDIC), are locked in by the issuing bank until the maturity date of the CD. Maturity dates for these savings instruments are typically set at three months, six months, one year, or five years. The higher the term for which funds are committed, the higher the interest paid. To take advantage of the various interest rates offered for different time periods, investors can follow a strategy known as the CD ladder.

How to Build a CD Ladder

Let’s say you have $20,000 to invest and want to build a four-year CD ladder.

Step 1: Open separate CDs

Rather than putting all the funds in one CD, you put $5,000 in each of four CDs that will mature in one, two, three, and four years. You look to find banks with the best rates on CDs before investing the funds. What you start with is:

Step 2: Renew and convert each CD at maturity

As each CD matures, you renew it as a four-year CD. By doing so, after four years you will have four four-year CDs, but only one of those CDs will mature annually.

If you had opened all of your CDs in January 2021, setting up the ladder would look like this:

This would allow you to leverage the higher interest rates on the longer-term CDs while building the ladder and to pull out 25% of the funds from the ladder per year without penalty by virtue of one CD maturing each year.

Mini CD Ladders

A mini CD ladder is the same concept as a regular CD ladder but with shorter-term CDs. You could build a CD ladder out of three-month, six-month, nine-month, and one-year CDs to deploy the same strategy. Keep in mind, though, that by building a ladder with shorter-term CDs, the interest rates you’ll be able to get will be lower.

Benefits of a CD Ladder

A CD ladder strategy is followed by investors who value the safety of their principal and income. It also provides you with steady cash flow, as the CDs will mature at different times. By spreading the investment over CDs with varying maturities, you benefit from the higher interest rates of longer-term CDs and do not have to repeatedly renew a short-term CD that holds all your funds.

CDs also offer FDIC insurance against default should a bank become insolvent. With the exception of U.S. Treasury bonds (T-bonds), which are also backed by the federal government, no other vehicle offers equivalent protection for fixed-income investors.

Additionally, by laddering your CDs you are able to customize their aggregate (or total) rate of interest, generally on the upside. If, for example, you only purchase three-month CDs to produce quarterly cash flows, you'll realize a relatively low rate of return. With a laddered CD portfolio, however, you can still achieve quarterly payments but with a much higher total portfolio rate of return, because longer maturity CDs generally pay higher interest.

If you put all your funds in one CD, you may miss out on a rise in interest rates that occurs while your funds are locked away. With a CD ladder, however, you can take advantage of short-term interest rates by reinvesting proceeds from maturing CDs into newer CDs with higher interest rates. On the other hand, if interest rates fall, you still enjoy the benefits of the high interest rates that your existing long-term CDs provide. A CD ladder, thus, provides regular opportunities to reinvest cash as the CDs mature while reducing interest rate risk. In the event that an emergency ensues and you need cash, the laddering strategy ensures that you consistently have a CD maturing, thereby reducing liquidity risk.

Special Considerations

As with any other investment, the practice of using laddered CDs depends entirely on your personal financial goals. Generally speaking, they are great for people who want safety of capital, predictable cash flows, and simplicity. CDs are very easy to understand, access, and structure to meet your financial goals.

On the other hand, the rates of return for CDs are generally low due to the safety they offer. Moreover, they provide no special tax treatment to save money on local, state, or federal taxes. Therefore, if you are in a high tax bracket, they are difficult to justify. If you are in a low tax bracket, they make a lot more sense.

Just keep in mind that the safest course of action with CDs is to go through your bank and make sure your deposits are covered by FDIC insurance limits. If you decide to go through a brokerage house, understand that you have introduced a variety of risky variables, including commissions, the questionable motivations of salespeople (the broker), and potential loss of principal. Keep it simple in order to reap the benefits.