Any healthy portfolio includes some cash investments. Because cash comes with relatively high liquidity, and because it is generally considered safe (you are nearly always guaranteed to get your principal back, plus interest), it is an important part of your investment portfolio, providing a safety net and almost immediate access to emergency funds if needed. However, the high liquidity and safety of cash comes with a price: Low returns. Because the yield on cash is so low, it is up to you to make the most of it. And one of the ways that you can do this is to set up a CD ladder.
What are CDs?
A certificate of deposit (CD) is a financial product that allows you to earn a higher rate of return on your cash. A CD is a time deposit. You agree to keep your money with a financial institution for a specific period of time, and that institution agrees to pay you a fixed rate of return. Your yield will not fluctuate with market conditions. This is an advantage in a climate where interest rates are dropping, since you will still earn a higher return. The down side is that when interest rates are rising, you can’t take advantage of them without incurring a penalty for early withdrawal.
CDs are insured by the FDIC (banks) and the NCUA (credit unions) for up to $250,000 each, until 2014 when the limit reverts to $100,000 (it's now permanent). This means that if the bank or credit union you are using folds, you will still be able to get your money.
A CD pays a higher rate of return than a savings account. Generally, the longer you are willing to keep your money in a CD, the higher your rate of return. You can invest in a CD for as little as one month, and as long as 10 years. If you withdraw money from your CD before it matures, you will have to pay a penalty, so it is important to plan your CD investing so that you are able to get access to your money regularly, and still be able to benefit when interest rates rise. A CD ladder can help you plan your access to this cash.
CD laddering is a strategy that allows you to take advantage of the higher cash rates offered by CDs, while at the same time ensuring that you have access to your money regularly. The most common type of CD ladder is the five year ladder. In this scenario, you open five different CDs. Let’s say that you check your savings account, and you have $15,000. You want to keep $5,000 for emergency purposes (move it to a high-yield savings account if it isn’t in one already), but use the remaining $10,000 to get your CD ladder started. Instead of locking that entire $10,000 away, here is what you might do:
- $2,000 in a one year CD at 1.80%
- $2,000 in a two year CD at 2.25%
- $2,000 in a three year CD at 2.60%
- $2,000 in a four year CD at 2.90%
- $2,000 in a five year CD at 3.20%
In one year, your first CD will mature. At that time, you will have $2,036. If you don’t need that money, you invest it all in another five year CD, at the prevailing rate (which you hope is higher by now). This new five year CD will mature at year six of your plan, keeping the ladder going. When your two year CD matures, you reinvest that in another five year CD, which will mature at year seven of your plan. As a result, every year you have a maturing CD. As you continue with your CD ladder, your yields will start to add up to something a little more substantial, especially if interest rates start rising.
The main drawback to this plan, of course, is that you only have access to your money once a year without penalty. You have to plan your finances around when this money will be available. If you don’t end up needing the money, though, you can keep the ladder going for years, creating a safe place for a chunk of your portfolio. If you do need some of the money, you take what you need and re-invest the rest. If you find that you have a little extra cash, you can add it to your CD each time you decide to re-invest to keep your CD ladder active.
If you a larger amount of investible assets, you can take advantage of jumbo CDs, which provide a higher interest yield. These are CDs that contain at least $10,000. The more money you put into a CD, the higher your rate of return. You can even set up a CD ladder working up to 10 year CDs with higher rates. Long term CD ladders comprised of jumbo CDs can be a good way to put the cash portion of your investment portfolio to work for you in a risk free way. While you probably won’t make phenomenal returns, you will be able to preserve your capital.
Short-term CD Laddering
In some cases, you might not be interested in long-term CD laddering. Instead, you might want access to your money more often. You can set up a CD ladder to put your money to work for you using CDs that mature in three, six, nine and 12 months. When your three month CD matures, you can take the money that you need (in any) and put the rest into another 12 month CD. This way, every three months, you have access to your funds. A small emergency fund in a high yield savings account can help you when you need immediate liquidity. Another option is to consider a no penalty CD. A few banks offer these types of CDs, which allow you to withdraw your funds early without fees. As with all investments, though, this flexibility comes with a caveat. You will earn lower yields on a no penalty CD – sometimes as much as 0.5% or even 1% lower. However, if access is what you want, it may be worth the trade off to include no penalty CDs in your CD ladder.
It is important to note that you have to pay income tax on the interest you earn from your CDs. The interest earned is reported as income on your Form 1040 each year, even if you don’t withdraw any money. You should receive a statement of your interest income from your bank. Consult with a tax professional to make sure that you are properly reporting your income from your CD laddering strategy.
Diversifying Your CD Ladders
Like any other type of investment, it is possible to diversify your CD investments. You can have long term ladders, meant to hedge against falling interest rates, used along with short term ladders that allow you take advantage of rising interest rates. Having a mix of long and short term CD laddering can also help you stagger maturity times so that liquidity is less of a problem.
Even though cash investments are low yielding, their safety makes them vital to a well-rounded portfolio. You can enhance your cash yields with CDs, and you can offset the limited liquidity of CDs while hedging against changes to interest rates by employing a CD laddering strategy.