A “CD” or “Certificate of Deposit” is a financial instrument in which you essentially loan your money to a bank for a fixed rate of return for a set amount of time. Generally the longer the amount of time (known as the “term”), the higher the interest rate will be. Most CDs range from one to five years, although many banks offer three, six, and eighteen month CDs. Most banks charge a penalty for withdrawing funds before a CD matures. For this reason, most people do not want to tie up their money for five years in case they need it for emergencies. Building a CD ladder is way to maintain the highest rates of interest while maintaining a decent level of access to your funds.
A CD ladder is built by essentially staggering several CDs for longer terms. A common CD ladder is built with five CDs of equal value ranging from one to five years. For instance, on the same business day, you would purchase a one, two, three, four, and a five year CD. The following year the one year CD would mature, and you would then renew it at the five year rate. This would put that CD at the top “rung” of your ladder. By repeating this process every year for four years, you end of with five CDs all earning the higher five year rates. This enables you to earn the higher rates of interest while still being able to access a portion of your funds each year, if needed, without penalty.
This method also helps to smooth out the peaks and valleys of interest rates as they change from year to year. CD ladders can be built with as many CDs at as many different rates that you want. If rates are really low, as they are now, you may want to build a shorter term ladder. You may not want to get stuck with a lot of low rate CDs if rates start to rise. The key is to try to get the best rates by using longer term CDs without having to sacrifice liquidity.
Sample of a CD ladder:
Start of Ladder:
Rung 1: 1 year CD, 1 year remaining
Rung 2: 2 year CD, 2 years remaining
Rung 3: 3 year CD, 3 years remaining
Rung 4: 4 year CD, 4 years remaining
Rung 5: 5 year CD, 5 years remaining
End of Year 1:
Rung 1: 2 year CD, 1 year remaining
Rung 2: 3 year CD, 2 years remaining
Rung 3: 4 year CD, 3 years remaining
Rung 4: 5 year CD, 4 years remaining
Rung 5: 5 year CD, 5 years remaining (Old 1 year CD from the previous year)
End of Year 2:
Rung 1: 3 year CD, 1 year remaining
Rung 2: 4 year CD, 2 years remaining
Rung 3: 5 year CD, 3 years remaining
Rung 4: 5 year CD, 4 years remaining
Rung 5: 5 year CD, 5 years remaining
End of Year 3:
Rung 1: 4 year CD, 1 year remaining
Rung 2: 5 year CD, 2 years remaining
Rung 3: 5 year CD, 3 years remaining
Rung 4: 5 year CD, 4 years remaining
Rung 5: 5 year CD, 5 years remaining
End of Year 4:
Rung 1: 5 year CD, 1 year remaining
Rung 2: 5 year CD, 2 years remaining
Rung 3: 5 year CD, 3 years remaining
Rung 4: 5 year CD, 4 years remaining
Rung 5: 5 year CD, 5 years remaining
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