CDs are a very safe investment because they come with built-in insurance. Up to $250,000 of your money at each bank is covered under the Federal Deposit Insurance Corporation (FDIC). Deposits at credit unions are also covered for the same amount by the National Credit Union Administration (NCUA).
However, CDs do have some major downsides. They’re basically just reverse loans you make to a bank, and therefore you can’t withdraw your money before the term of your loan ends without paying stiff fees.
To get around this, some people buy short-term CDs so they can have more frequent access to their money in case they need it, but these short-term CDs offer far lower returns than longer-term CDs.
It’s a big quandary: The best CD rates are for longer-term CDs, but it’s a tough commitment to lock your money up for that long.
That’s where a little-known tool called a CD ladder comes in: It provides a neat solution that allows you to invest in long-term CDs while having frequent access to your money at the same time.
What is a CD ladder?
A CD ladder is basically a series of staggered investments. Rather than putting all your money in one CD and never seeing it again for five years or longer, you split your total investment among several smaller CDs. Each one of these smaller CDs has a different term so they mature (are paid back to you with interest) at different times.
The goal with CD laddering is to plan your smaller CDs out ahead of time so you’ll have one new CD maturing at regular intervals. When this happens, you have the option to take the money out, or you can reinvest it in the coveted long-term CD.
By the end of the cycle, all of your smaller CDs will be invested in long-term CDs. One new CD will mature after each time interval. Thus, your goal is achieved: All of your money is invested in the highest-earning CDs, yet you still have frequent access to a portion of your cash.
Are CD ladders right for you?
CD ladders are a great tool for people who have a hard time saving money because they’re always pulling cash out of their savings for unplanned expenses like a spur-of-the-moment vacation or a last-minute holiday gift. CDs are essentially forced savings accounts – you can get the money out if you need it, but not without paying a price.
Each financial institution charges fees for early withdrawal. Fees can be a set dollar amount, a set number of months’ worth of interest, a set percentage of the principal (the amount you invested), a set percentage of interest (the amount you’ve earned), or a set percentage of both principal and interest.
You could still come out ahead if you’re just charged a percentage of interest, or you could end up actually owing the financial institution money if they have steeper fines. Needless to say, it’s something you should avoid at all costs – even if there’s a tempting last-minute deal on a cruise vacation.
CD ladders are also great savings tools for when you need a specific amount of money in the short term – for example, if you’re looking to save a down payment for a house five years from now, or a car in three years.
Finally, CD ladders are also great tools for people who meet two conditions: They already have money saved in an emergency fund, and they’re also saving in high-yielding investments like stocks or index funds, if they’re working on saving up for retirement.
You don’t want to keep your emergency savings in a CD ladder because if an emergency does happen, you won’t be able to pull out your money without incurring the fees described above. CD ladders are also great investment vehicles, but they don’t earn enough to allow you to really ramp up your long-term savings for things like retirement (more on that further down, though).
What are some examples of CD ladders?
The really cool thing about CD ladders is that you can customize them to fit your needs. The only two things you need to pay attention to are how frequently you want access to your money and how much you have to invest to create your own CD ladder.
All CD ladders follow the same basic principles of splitting up your total investment among multiple staggered investments. Here are two examples of CD ladders that offer you access to your money at different intervals and require different initial investments:
CD Ladder One: Short-term, smaller investment
Let’s say you only have $1,000 to invest. You could split it up into some short-term investments like this:
Start: Buy four CDs. Put $250 each into a three-month, six-month, nine-month, and one-year CD.
Every three months: One CD matures, and you can either cash it out or roll it over into a new one-year CD.
After one year: Each CD is invested in a one-year CD. Because they have staggered start times, one new CD will mature every three months.
CD Ladder Two: Long-term, larger investment
If you have $5,000 to invest, you could split it up and form a CD ladder this way:
Start: Buy five CDs. Put $1,000 each into a one-year, two-year, three-year, four-year, and five-year CD.
Every year: One CD matures and you roll it over into a new five-year CD, or you can cash it out without facing penalties.
After five years: Each CD is invested in a five-year CD. Because they have staggered start times, one new CD will mature every year.
How do CD ladders hold up compared to other investments?
It’s important to know how CD ladders stack up against other potential investments if you’re using them to save money. So we decided to compare an initial $5,000 investment over 10 years to see how CD ladders compare to other options.
It’s also important to take inflation into account when looking at your returns over several years, because this has a real impact on how much your money will be worth. If you started out with $5,000 in 2006, you’d need exactly $6,071.02 today to have equal buying power today, thanks to inflation.
Let’s see how our investments pan out:
Let’s consider the long-term, larger investment CD ladder structure from above and use the highest rates from MagnifyMoney’s CD comparison tool.
To start out, you’d put $1,000 each into a one-year, two-year, three-year, four-year, and five-year CD. For the next five years, one of these CDs will mature annually, and you will roll it over into a new five-year CD. By the time five years is up, all of your CDs will be in high-interest-earning CDs, with one maturing annually. Then we’ll continue rolling them over into five-year CDs for five more years, for a total of 10 years’ worth of rollovers.
Risk: Very safe because it’s backed by the FDIC or NCUA. You can also take advantage of higher interest rates if they go up.
Reward: $1,019.61. You’d need to make more than $1,071.02 to counter the effect of inflation, though, so your inflation-adjusted returns would be worth –$51.41 ($1,019.61 – $1,071.02).
Two Five-Year CDs
Let’s find out what happens if you take the initial $5,000 investment but put it into two back-to-back five-year CDs instead of laddering it.
Risk: Again, very safe because it’s backed by the FDIC or NCUA. However, you can’t take the money out as frequently if you need it, and you’ll only be eligible to take advantage of rising interest rates once when you roll it over into another CD.
Reward: $1,026. You’ll come out –$45.02 after taking inflation into account ($1,026 – $1,071.02).
The stock market is traditionally the best way to go for long-term gains. We wanted to know how much extra money you would have in 2016 if you invested $5,000 in the stock market way back in 2006. We looked at the average annual inflation-adjusted stock market return (7.92%), compounded annually over 10 years.
Risk: High; you could lose a significant portion of your money in the short term, and it can take a while to build it up again.
Reward: $10,715. This has already been adjusted for inflation, and so represents the real value of your money in 2016.
Most people like to save up money in a plain old savings account. We looked at what would happen to your money if you kept $5,000 in a savings account for 10 years. We used the rates from MagnifyMoney’s savings account comparison tool to find the highest-yielding A-rated bank (Ridgewood Savings Bank, 1.05% APY) and calculated returns using daily compounding.
Risk: Very safe because it’s backed by the FDIC or NCUA.
Reward: $554. You’ll come out –$517.02 after taking inflation into account ($554 – $1,071.02).
Under Your Mattress
Our grandparents might have squirreled away money under their mattress, but now that might not be the greatest idea. Here’s what would happen if you just kept $5,000 completely in cash for 10 years.
Risk: Very unsafe. It can easily be stolen or lost in a house fire.
Reward: $0. You’ll come out –$1,071.02 after taking inflation into account ($0 – $1,071.02).
CD ladder FAQs
- How can I find the best rates on CDs?
You can use MagnifyMoney’s CD comparison tool to find the best rates across the country for CDs of various term lengths.
- What are the shortest and longest possible CD terms?
Generally, three months is the shortest term offered while five or even 10-year CDs are the maximum terms.
- Will I owe taxes on my money?
Yes. You are taxed on your interest earning just like a regular savings account. Your bank will issue you a 1099-INT form at the end of the year.
- What if interest rates change?
You won’t be affected unless you possess either a callback or a bump-up CD. Callback CDs allow the bank to cancel your CD and return your principal and any yields to you if interest rates fall. Bump-up CDs give you the option to boost your interest rate once per term if interest rates rise.
Certificates of deposit (CDs) are a great way to diversify your portfolio. They’re easily available because just about every bank and credit union offers them, there are no tacked-on fees to buy them, and they’ll often earn much more interest than a regular savings account.