How to Build a CD Ladder
To improve their investment return on cash assets in a low-risk manner, many investors are re-assessing Certificates of Deposit (CDs) as good alternatives compared to savings and checking accounts. This article will review how CDs work, their benefits and disadvantages, and how to build a CD ladder.
WHAT IS A CERTIFICATE OF DEPOSIT?
A certificate of deposit (“CD”) is a receipt (certificate) you get when you deposit cash into a special form of savings account. Typically, CDs offer a better interest rate than a savings account. There are two primary types of CDs: Bank and Brokered.
- A Bank (“traditional”) CD is offered by banks and is sold directly by the bank. Bank CDs must be held in an account with that specific bank. A holder of this type of CD will often have to forfeit all or part of the interest payment if the CD is redeemed before its maturity date.
- A Brokered CD is issued by banks for customers of investment and brokerage firms. A brokered CD can be resold by the holder through brokerage firms at the market price. If the client wants to redeem before the CD’s maturity, the price may differ from the original purchase price of the CD, which may result in a gain or loss.
Typically, a minimum deposit amount will apply for both types of CDs, and the deposit amount is committed for a pre-defined period of time. This time commitment may vary from 21 days (or less) to 5 years (or more).
The longer the term of the CD, the higher the interest rate paid will typically be. This isn’t always the case, so research CD rates closely before making an investment.
The larger the minimum deposit rate for a CD, the higher the interest rate will typically be.
Once the CD term completes, the funds can be moved into a standard savings account, or may be reinvested automatically into a new CD with the same term as the expired CD.
BENEFITS OF CERTIFICATES OF DEPOSITS
1) Low risk: CDs are backed by the FDIC, up to certain limits.
2) Rate of return is predictable if the CD is held to maturity.
3) A CD will typically offer higher yields than the yields paid by bank savings and checking accounts or money market funds.
4) CD laddering strategies can help leverage changing interest rates and maintain liquidity.
DISADVANTAGES OF CERTIFICATES OF DEPOSITS
1) Access: CDs offer less liquidity than savings accounts, money market accounts, or checking accounts because the funds are committed for the term of the CD. Banks and credit unions can penalize savers who withdraw CD funds before the CD term is complete.
2) CD rates may not be high enough to keep pace with inflation. Investing the money in the stock market could generate significantly higher returns than CDs, particularly over longer terms.
HOW TO BUILD 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) of similar or equal amounts with different maturity dates. A CD ladder allows you to earn higher rates in the short term vs. other cash accounts while allowing for long-term flexibility with your money in case of emergencies, discretionary spending needs, or better investment opportunities. The principles are very similar to building a Bond Ladder, and a good way to explain the structure of a CD Ladder is via the example below.
In our example, the investor has $60,000 to invest, a 5-year investment time horizon, and wants to maintain access to a portion of the money on a regular basis, vs. locking the entire amount up for 5 years.
Our CD Ladder strategy will be to build a five-year CD ladder with 12-month increments.
Step 1: Open five separate CDs. Put $12,000 in each of five CDs that will mature in one-year sequences.
$12,000 in a one-year CD
$12,000 in a two-year CD
$12,000 in a three-year CD
$12,000 in a four-year CD
$12,000 in a five-year CD
Step 2: Renew and convert each CD when it matures into a new five-year CD. Five years from the initial creation of the CD ladder, the ladder will consist of five sequential five-year CDs, with one of those CDs maturing annually.
If the investor's time horizon changes, they can choose to halt the conversion of the maturing CDs into new CDs.
Factors to consider when assessing which type of CD to build your ladder with:
1) Different banks and brokerages offer varying CD interest rates and terms, so you should compare options from multiple institutions to find the highest interest rate paid for the term and minimum deposit amount you are targeting.
2) For Brokered CDs, closely examine the fees charged by the brokerage for CD purchases. These fees can diminish the advantage of a Brokered CD vs. a Bank CD.
3) Some CDs are “callable”, which means the issuing bank can pay it off early if interest rates decline. We recommend NOT using callable CDs in a CD ladder, because the ladder structure will be disrupted if any of the CDs are called.
4) Sometimes, the interest rate paid on longer-term CDs is lower than the rate paid on short-term CDs, which may lead an investor to question a long-term CD commitment. In this case, some investors may opt to build their CD ladder with shorter-duration CDs. Using the CD Ladder example cited above, the investor may opt to create four $15,000 CDs initially, with terms of 3 months, 6 months, 9 months and 12 months, then renew and convert each maturing CD into a new 12-month CD. This scenario currently exists (June 2023) as short-term CDs are paying higher interest rates than longer-term (>12 months) CDs.
5) For investors with significant assets to invest (>$250,000), they do not need to open accounts at different banks to ensure FDIC coverage (capped at $250,000 maximum investments in a given bank). Through many brokerages, these investors can purchase and hold Brokered CDs from multiple banks in a single brokerage account. In addition to convenience, this allows the investor to increase their FDIC coverage beyond the $250,000 maximum at an individual bank. They will have FDIC coverage for $250,000 in Brokered CD purchases from each different bank that sells the investor Brokered CDs through the brokerage account.
BOTTOM LINE
A CD ladder can provide flexibility to earn better returns on available cash than you would yield in a savings or money market account, while maintaining flexible access to a portion of the total cash amount on a regular basis. Since interest rates paid by banks and brokerage houses vary, the investor should compare options before opening or renewing the CDs. Consulting with a financial advisor can help you select the best investment strategy based on your individual circumstances.
Resources
1) https://www.capitalone.com/bank/money-management/banking-basics/what-is-a-cd-ladder/
2) https://www.schwab.com/fixed-income/bond-ladders
3) https://www.investopedia.com/pros-and-cons-of-cds-5223947
4) https://investor.vanguard.com/investment-products/cds
5) https://smartasset.com/investing/the-pros-and-cons-of-using-a-cd-ladder-to-build-savings
* This content is developed from sources believed to be providing accurate information. The information provided is not written or intended as tax or legal advice. Individuals are encouraged to seek advice from their own tax or legal counsel. Neither the information presented, nor any opinion expressed, constitutes a representation by us of a specific investment or the purchase or sale of any securities. Asset allocation and diversification do not ensure a profit or protect against loss in declining markets. This material was developed and produced by Eustace Advisors to provide information on a topic that may be of interest. Copyright 2023 Eustace Advisors.