Best Strategy for Your Savings - Alternatives to CD Ladders

With interest rates so low, you may have second thoughts about buying new long-term CDs. For those with CD ladders, maturing CDs are rolled over into new CDs regardless of the interest rate environment. Instead of continuing or starting the traditional CD ladder with long-term CDs, you may want to consider alternatives. I thought it would be useful to review a few CD ladder alternatives that could provide better returns and more liquidity in today's very low interest rate environment. Some of these alternatives are variations of the traditional CD ladder that could provide a little better rate of return if interest rates do shoot up in the next year or two.

Alternative #1: High-Yield Savings Accounts

This maximizes liquidity, and rates will rise once the interest rate environment improves. However, while you wait for interest rates to rise, you are currently losing out between 1% to 2% in yield. That's about the difference between the top internet savings accounts (currently from 1.50% to 2.00%) and the best 5-year CD rates (currently from 3.25% to 3.50%).

Alternative #2: High-Yield Reward Checking Accounts

With reward checking you have about the same liquidity as the savings accounts, but rates can be just as high (and even higher) than 5-year CD rates. This may seem like the perfect alternative to the CD ladder. However, if you have a lot in savings, the reward checking balance caps will be an issue. Most have caps of $25K. Those that have larger caps usually have lower rates. Balances over the cap will earn a much lower interest rate. You can have multiple reward checking accounts to get around this cap issue, but this takes more work to meet the debit card usage requirements.

Another potential issue with reward checking accounts is that there's no guarantee on the yield. Back in 2007, there were many reward checking accounts paying 6% APY with no balance caps. Those who decided to keep all their savings in these accounts may have wished they had taken advantage of PenFed's 6% long-term CDs. Most of those 6% reward checking accounts are now paying under 4%.

Alternative #3: Low-Penalty Long-Term CDs without Laddering

When a CD ladder has been established, the CDs should be maturing at regular intervals. This serves two purposes: 1) Liquidity - A portion of your money can be accessed without an early withdrawal penalty and without too much time, 2) Higher interest rates - Each time a CD matures, you can roll it over into a new CD that can take advantage of higher CD rates (assuming interest rates are rising).

These two purposes can be achieved with low-penalty long-term CDs without laddering. An example of such a CD is the 5-year CD at Ally Bank that currently has only a 60-day early withdrawal penalty. If you need the money, you can just break one of the CDs. The money lost to the penalty is minimal. If rates have gone up so that similar 5-year CD rates are much higher, you can break the CDs and reinvest into the higher paying CDs. With a small penalty, it won't take much time for the higher paying CDs to make up for the money lost to the penalty.

One downside with a low-penalty CD is that the interest rate may not be the best. You will likely be able to get a higher rate on a CD with a more traditional early withdrawal penalty at another bank or credit union.

One potential issues with this approach is that the bank may not allow an early withdrawal regardless of the penalty. Some CD disclosures give the bank the right to refuse an early withdrawal request, and I have heard about cases in which this has occurred (see post).

A similar issue is if the bank increases the early withdrawal penalty during the CD term. Many have been concerned about this possibility at Ally Bank. There should be no chance of this based on the assurances I received from an Ally Bank official (see post).

Alternative #4: Short-Term CD Ladders

CD ladders don't have to invest in long-term CDs. CD ladders could start with 3-month, 6-month 9-month and 1-year CDs. When the short-term CDs mature, you roll those over into 1-year terms. The advantage of the short-term CD ladder is that you don't lock into long-term CDs at a time of very low interest rates. When interest rates rise, you'll quickly start to take advantage of the higher rates as your CDs mature every 3 months.

The problem with this approach is that you don't earn a yield that's much better than a savings account yield. In fact, most CDs with maturities under 1-year have yields less than the top savings account yields. Currently, it's hard to find 3-month CD yields above 1%. For 12-month CDs it's hard to find rates above 1.75%.

Alternative #5: Barbell CD Ladder

Instead of all long-term CDs in a CD ladder, you could use a barbell strategy in which only half of your money is in long-term CDs. The other half could be in short-term CDs, savings accounts or reward checking accounts. The long-term CDs will do better if interest rates stay low. The liquid accounts may do better if interest rates shoot up.

Bottom Line

If you want to keep things simple for your safe money, a traditional CD ladder with long-term CDs works well. It does not require you to predict future interest rates. These CD ladder alternatives may have better returns if rates shoot up in the next year or two. Rates will eventually rise, but no one knows when. The longer this rate environment continues, the better the traditional CD ladder strategy will be in terms of the best rate of return.