What is a CD ladder?

A CD ladder is an investment strategy in which a fixed amount of money is divided equally among multiple certificates of deposit purchased at varying maturity dates. The purpose of a CD ladder is to allow investors to manage both interest rate and liquidity risk. Before going into more detail about a CD ladder, it’s important to understand what a certificate of deposit is and the role it can play in an investor’s portfolio.

A certificate of deposit is a financial product that allows a financial institution (such as a bank or credit union) or brokerage firm to hold a depositor’s funds until a fixed maturity date in exchange for a fixed rate of return. Because the principal within a CD is FDIC insured, a CD is considered to be a virtually risk-free investment.

Although in some cases, a depositor can cash out their CD before its maturity date (with a penalty), the implied tradeoff is that the owner of the CD is taking a liquidity risk (i.e. not having access to their money) for the guaranteed of a higher interest rate than they can get through another savings vehicle such as a savings account or money market account.

All interest rates advertised for a CD are based on an annual percentage yield. So a CD paying 3% would mean that an investor who puts $1,000 into a one-year CD would receive $1,000 plus the 3% interest at the end of the first year. Since the interest earned on a certificate of deposit is compound interest, the value of the CD at maturity would depend on how frequently the interest was compounded. Most CDs will compound interest daily or monthly.  This can make a significant difference in the value of the CD at maturity.

At maturity, investors have two options. The first option is to simply cash out the CD, usually into their existing checking or savings account if the CD is purchased through a bank. The second option is to re-invest the CD into another CD. This allows investors to continue to take advantage of compound interest. It's also a way to hedge against fluctuating interest rates. CD ladders are a common technique used when re-investing CDs.

One of the benefits of a certificate of deposit is that the interest rate is locked in. In our example above, if an investor purchases a four-year CD with an interest rate of 3.0 percent, the interest rate will remain at 3.0 percent no matter what decision the Federal Reserve makes on the benchmark Federal funds rate throughout the period of time they own the CD. So even if the economy has a downturn and the Fed lowers interest rates in an effort to stimulate the economy, an investor is guaranteed the interest rate that was in place when they bought the CD. In exchange for the guarantee of receiving a higher interest rate, investors agree to keep their money in the certificate of deposit until its maturity date (in some cases, an investor may withdraw the CD but will have to pay a penalty which will eliminate any interest benefit and also will mean they do not receive the full amount of principal invested).

However, while a CD offers great insurance against falling interest rates, rising interest rates create a risk for CD owners. For example, what if during the first year of owning a four-year CD, the interest rate of a four-year CD climbs from 3.0 to 3.25? The investor is locked into their current CD and they would miss out on the gain from the higher rate. By executing a CD ladder strategy, an investor can reinvest a maturing CD and lock in the new, higher interest rate.

Most CDs offer maturity periods as short as three months and as long as five years. When considering what length is right for their laddered portfolio, an investor must consider their personal financial situation. For example, if they are self-employed or work in an industry that has high turnover, they may want to consider shorter maturity dates that will allow them to have access to their funds – without penalty – at more frequent intervals. Also, if an investor feels that interest rates are likely to rise in the near future, they may choose a shorter term so that they can more easily move their money to a product with a higher interest rate. Using shorter maturity periods can also be an effective strategy for funding an emergency fund with three to six months of living expenses. CD ladders can be set to expire on a quarterly basis with the maturing CD either being reinvested into other CDs or cashed out and placed into a high-yield savings account.

For some younger investors, a good strategy is to start with short-term CD ladders and, as their cash account increases, begin to set aside some of the money in longer ladders while still maintaining approximately three to six months of emergency cash in short-term ladders.

Once an investor decides they want to engage in a savings strategy such as a CD ladder, they will find there is no shortage of options for finding where to buy them. Even in this era of low-interest rates, CD rates are advertised prominently by any bank or credit union. However, online banks have become viable banking sources. These banks do not have the physical costs of a brick-and-mortar bank and therefore can frequently offer higher yields. These online banks, such as EverBank, can offer highly competitive interest rates and may even offer a wider variety of products such as step-up CDs, bump-up CDs, or IRA CDs. Most CDs require a minimum deposit that increases along with the yield. And as stated before, although the funds in a CD are FDIC insured, they come with early withdrawal penalties.