- Personal Finance»
- Banks, S&L's, Credit Unions
How a CD Ladder Investment Strategy Works
What Is a Certificate of Deposit (CD)?
Many investors know of the CD ladder investment strategy (also known as CD laddering), but few understand what this investment strategy is, when it makes sense to use it, and why it can be the best way to invest in fixed rate securities. With the United States Federal Reserve ending Quantitative Easing (QE) and interest rates expected to rise for several years, as the economy picks up stream, using a CD ladder investment strategy, as outlined below, makes a lot of sense. CD laddering allows conservative investors to capture higher rates of return from CDs than simply making a large investment in CDs. Read on, and you will understand why CD laddering is a solid investment strategy during times of rising interest rates.
A Certificate of Deposit (CD) is a promissory note that banks issue that promises to pay a fixed rate of interest that is paid for a specified period of time. The interest is either paid without compounding, known as the annual percentage rate, or is compounded on a periodic basis during the year (i.e., every week, every month), which is known as the annual interest yield. CDs can be purchased that cover periods that range from three months to ten years. Longer duration CDs, pay higher interest rates than shorter ones. The interest rate paid by banks to purchasers of CDs increase as short-term interest rates increase, which is what is expected to happen over the next few years.
The CD Ladder Investment Strategy
An Explanation and Example of the CD Ladder Investment Strategy
A CD ladder investment strategy is simply making CD investments at time intervals, as interest rates rise, to capture higher CD yields as they become available. Instead of buying all the CDs one intends to buy all at one time, while interest rates are low, using a CD ladder investment strategy, investments are staggered over time, with the expectation that CD yields will rise. The goal of a CD ladder investment strategy is to average into CDs over time to capture a higher average CD annual interest yield than would be attainable if all the money dedicated to CD investing is invested when CD yields are low at the beginning of the time period.
For example, if an investor has $200,000 to invest in CDs and CDs that mature in five years currently pay a 2% annual interest yield, but yields are expected to rise over time, it would make sense to hold off and invest the $200,000 in stages as CD yields rise. To implement a CD ladder investment strategy during a rising CD interest yield environment, an investor would invest the $200,000 in stages, with each CD investment made at a higher CD interest yield, as rates yields over time. For the purpose of this example, let’s say an investor using the CD ladder investment strategy invests $50,000 every six months in CDs that mature in five years until the investor has invested $200,000 into five year CDs. It would take two years for the investor to invest the entire $200,000. If interest rates rise as expected, let’s say from 2% to 4% over the two year period, then the investor will have averaged into five year CDs that with an 3% average interest yield. This provides them an additional 1% interest yield than they would have earned if they had committed all of the $200,000 to a five year CD when they were initially yielding 2%.
In reality, any time interval can be used by an investor that wants to implement a CD ladder investment strategy. The timeframe can be shortened or lengthened and amounts adjusted according to changes in the interest rate environment and outlook. The key is to average into CDs as their yields increase over time to capture the higher yielding CDs that are issued later in the timeframe.
Just keep in mind that redeeming a CD before it reaches its maturity date will in most cases result in penalties by the issuer of the CD. Early-withdrawal penalties can be substantial and can be found in the CD purchase agreement provided by the issuer. If money invested in CDs may be needed before the CDs are scheduled to mature, it would be a good idea to invest in CDs with shorter maturity timeframes or to just keep the money in an account that provides easy access to withdrawals without penalties, such as a money market or savings account.
The CD Ladder Investment Strategy at Work
Why Use a CD Ladder Investment Strategy
There are two primary reasons to use a CD ladder investment strategy during periods in which interest rates are rising. 1) As CD interest yields paid by banks rise, the CD ladder investment strategy allows an investor to average into CDs at higher yields. 2) Because the CDs are purchased over the course of a number of months or years, they will mature at different times in the future. This frees up cash in stages for either reinvestment in CDs at even higher yields, if interest rates are higher than they were previously, or for other investment options that make sense in a future economic climate.
How To Construct A CD Ladder
Ways To Protect CD Investments When Using CD Laddering
Bank failures are always a concern when investors invest their money with banks. The good news is that CDs are protected by the Federal Deposit Insurance Corporation (FDIC), if they are purchased from FDIC-insured banks and do not exceed the $250,000 FDIC insurance maximum. If an investor has more than $250,000 to invest in CDs, it is very important to not invest more than $250,000 in any one bank to ensure that the money invested in CDs is covered by FDIC insurance. Investors with greater than $250,000 to invest in CDs should split their CD investments among several FDIC-insured banks to keep their CD investments below the $250,000 insurance threshold, so they can rest easy that their money is insured.
Disclaimer: This article was not written by a financial professional or a registered financial advisor. This article is for informational purposes only, and is not intended to be solicitation or recommendation to purchase any CDs or securities mentioned herein. Please consult a registered financial advisor to ensure you understand the risks and rewards associated with buying and selling CDs and other financial products.