Understanding the CD Ladder Strategy and Its Benefits
A certificate of deposit or CD is an investment or savings tool. CDs have a higher interest rate than standard savings accounts, which is why many investors use them within their portfolios. However, to make the most of the various interest rates available, an investor might use a CD ladder strategy.
A CD ladder reduces the risks of interest rates and reinvestment. An investor will divide a sum of money equally across several CDs. The strategy can work with long and short-term CDs, such as one, two, three, and four options or three-month, six-month, nine-month, and one-year options.
The strategy you use will depend on your overall comfort level with the strategy. Once the money is locked into a CD, it cannot be accessed without penalty. Additionally, the longer the commitment, the higher the interest, so it is worth focusing on long-term ladders.
Building Your First CD Ladder
When creating your CD ladder, the first objective is to determine how much of an investment you are willing to make. To make it easy, consider you have $16,000 you wish to invest. You will first need to divide that into equal parts. Most CD ladders contain four accounts, so $16,000 divided by four equals $4,000 to each account. Your initial ladder would look something like this:
- $4,000 invested in a one-year CD
- $4,000 invested in a two-year CD
- $4,000 invested in a three-year CD
- $4,000 invested in a four-year CD
You are set to have four four-year CDs with the established CDs eventually, but with only one maturing per year. Therefore, as each CD reaches maturity, you can leverage higher interests rates and pull 25% of funds from each ladder without penalty as it matures. Ultimately, if you opened all CDs in March of 2022, your ladder would develop like so:
- March 2023: renew one-year CD to a four-year CD
- March 2024: renew two-year CD to a four-year CD
- March 2025: renew three-year CD to a four-year CD
- March 2026: renew four-year CD to a four-year CD
Understanding the Benefits of a CD Ladder
There are two primary benefits of using a CD ladder strategy: FDIC protection and principal and income safety. The Federal Deposit Insurance Corporation protects CDs and investment funds up to $250,000. Additionally, once you invest money into a CD, the funds are locked in, meaning your principal remains intact, increasing by the promised interest rate.
While CDs offer a more secure investment, it is necessary to point out that the strategy is not the most lucrative option. When it comes to earnings from investments, the greater the risk, the greater the reward. Still, despite the limited earnings potential, a CD ladder does provide investors with quarterly earnings and minimal risks.
A CD ladder is a solid investment or savings strategy for people who do not like risks and wish to protect their principal and income. It is a strategy that allows investors to make the most out of higher interest rates. However, it is vital to understand it for what it is, a savings vehicle.