Certificate of deposit ladders were once seen as easy sources of dependable investment income. If you were willing to build a ladder of CDs with regular maturity dates, you would end up with a guaranteed high rate of return.
Of course, during the recent economic crisis, no one wanted to offer high interest on anything and CD ladders became less attractive. Now, banks are once again offering higher interest rates for CDs, which means more opportunities for you to make these unique investments.
So, is it still worth it to climb the CD ladder?
It all depends on two things: how much money you have, and how long you’re willing to wait to get it back.
Let’s back up a bit to understand the process.
What’s a CD Ladder?
To understand how a CD ladder works, we first have to discuss how CDs work.
CDs, or certificates of deposit, are one of the few guaranteed investments out there. Stocks rise and fall, and even the interest rate on your savings account changes. When you buy a CD from a bank, you are guaranteed the interest promised to you at the time of purchase.
Why do banks offer CDs? The same reason they offer savings accounts — they want to hang out with your sweet money and let it earn money for them. Of course, with a savings account, you can withdraw your money whenever you want. Banks would prefer to keep your money for a guaranteed amount of time, which is why they created the certificate of deposit.
With a certificate of deposit, you essentially say, “Hi, bank. I will give you this amount of money for a guaranteed amount of time, and will not withdraw it until the deposit term is complete.” Then the bank says, “That is awesome. In exchange, we will give you a guaranteed high interest rate on your deposit.”
Here’s the most important part: You and your bank agree on the CD term length in advance. The longer the term length, the higher interest rate you receive.
Since many people don’t want to lock up all of their extra money in CDs that they can’t access for a year or more, they create a CD ladder: an escalating series of CDs that gives you access to the highest interest rates while still making sure you have money in your pocket when you need it.
How Does a CD Ladder Work?
Imagine you want to invest $3,000 in CDs. You want a high interest rate, but you also want access to your money when you need it. So you invest your $3,000 as follows:
- $1,000 in a six-month CD (with a low interest rate)
- $1,000 in a 12-month CD (with a medium interest rate)
- $1,000 in an 18-month CD (with a high interest rate)
At the end of six months, you get your initial $1,000 investment back plus the interest earned. You now have two options:
- Keep the money
- Invest the $1,000 plus interest in an 18-month CD
Another six months pass, and now your 12-month CD comes due. You get your $1,000 investment plus interest, and can either keep it or invest it in an 18-month CD.
Six more months pass, and your first 18-month CD comes due. You can choose to spend it, or you can immediately invest it in another 18-month CD.
Let’s assume you always reinvest your money. From this point on, you have three 18-month CDs, each of which is earning you high interest. Every six months, one of your 18-month CDs comes due. You can spend what you need, and reinvest the rest in another 18-month CD.
It’s an excellent way to maximize your interest without taking on a lot of financial risk. Set up a series of 18-month CDs or build an even longer ladder that lasts five years or more.
Is it Worth it to Climb the CD Ladder?
If you have a decent amount of savings (say $1,000 or more) and you want the security of a guaranteed return, a CD ladder is a great choice.
Longer-term CDs give you much higher returns. For example, GE Capital offers a 0.70% APY for a 6-month CD, but a 2.25% APY for a five-year CD. Your local bank probably also has CD ladder options, and most banks even have online interfaces that let you create a CD ladder in minutes.
Image courtesy of GE Capital
If you don’t yet have enough savings to start a CD ladder, start hoarding those pennies and check out our posts on earning more money. Once you have enough savings, give the CD ladder a try and see where it takes you.
Your Turn: Have you tried laddering your CDs? How did it work for you?
Nicole Dieker is a freelance copywriter and essayist. She writes regularly for The Billfold on the intersection of freelance writing and personal finance, and her work has also appeared in The Toast, Yearbook Office, and Boing Boing.