In today’s ever-changing financial landscape, finding reliable opportunities for steady growth and secure savings is crucial. This is where certificate of deposit (CD) ladders come into play. CD ladders are growing in popularity because they provide a balanced approach in building and managing your finances. But what is a CD ladder and how does it work? In this blog, we will discuss the essential features of this savings strategy, one rung at a time.
Certificate of Deposit (CD) Definition
Before we explore CD ladders, let’s quickly revisit the basics of CDs (certificates of deposit). A CD is among the safest savings choices available, and it is FDIC insured. It works as a specialized savings account, holding a fixed amount of money for a specific period of time (spanning from a few months to several years). This duration acts as a lock-in period for your interest rates, ensuring that the returns are set throughout the investment term. While funds remain in your account during this timeframe, withdrawals are restricted. In return, when the waiting time is over (once the CDs reach “maturity”), you’ll receive your initial investment plus accumulated interest.
In other words, you deposit money into a bank account for a fixed length of time without touching it. Once the time is up, you can access your money again, but the amount of money has increased.
What is a CD ladder?
A CD ladder is a savings strategy where you invest several certificates of deposit with different maturity dates. Instead of putting all your money in one CD, you divide it across multiple CDs for different lengths of time.
This technique allows you to access and redeem your funds more often than if you put all of your savings in long-term CD, while still reaping some long-term and predictable benefits.
How do I make a CD ladder? How does it work?
To create the “laddering effect,” stagger the maturity dates based on your investment timeline and future needs for money access. As you build your ladder, keep in mind that your CDs don’t have to be the same amount, or even with the same bank or credit union.
Additionally, it’s important to note that you need a minimum of three CDs (or rungs) for a ladder, but a traditional CD ladder typically has five rungs spaced six months to one year apart. See below an example of a traditional ladder.
If you have $5,000 to invest, then it might look something like this:
- CD #1: $1,000 with 1-year term at 5.25% APY → Reaches $1,052.50 at maturity
- CD #2; $1,000 with 2-year term at 4.50% APY → Reaches $1,090 at maturity
- CD #3: $1,000 with 3-year term at 4.30% APY → Reaches $1,129 at maturity
- CD #4: $1,000 with 4-year term at 4.00% APY → Reaches $1,160 at maturity
- CD #5: $1,000 with 5-year term at 3.40% APY → Reaches $1,170 at maturity
When the first CD matures after a year, you can either pocket the money or build the next rung of your ladder by reinvesting the funds into a new CD (in our example, this would be CD #6). Of course, you could do a combination of the two by pocketing the interest you have earned and then reinvesting the original amount with a higher interest rate. Once the two-year CD becomes available a year later, you can repeat the process.
In the above example, we reach the total at maturity by adding the original deposit amount and the interest earned. (Interest Earned = Deposit Amount x Interest Rate x Time)
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Tip: Mark your calendar with each CD maturity date. Certain CDs may renew automatically, so it’s wise to plan ahead and decide how you intend to manage each CD when the time comes. |