Who Should Be Using a CD Laddering Strategy
Using a CD laddering strategy when investing in Certificates of Deposit (CDs) is a smart move as the United States transitions into a period in which interest rates are expected to rise, as the United States Federal Reserve reverses its long-standing near zero interest rate policy. The CD laddering strategy is a time-tested way of getting the most out of fixed-income Certificate of Deposit investing. While it takes some time and patience to implement, this strategy pays off well for those that use it, since it provides investment flexibility as time passes.
To be perfectly clear, a CD laddering strategy is not right for all investors. If you need to put money into a Certificates of Deposit for a specific need in the future, such as a new car you anticipate buying in two years, then you would be better of just buying a Certificates of Deposit that expires in two years. The CD laddering strategy is also not suitable for investors looking to make fast money. The type of investor that would benefit from using the CD laddering strategy is an investor that wants to invest their money in safe fixed-income securities, but also wants to maximize their investment returns. While CD laddering will not provide the incredible investment returns that momentum stocks provide; it does provide a way to maximize returns when an investor is seeking to invest safely in fixed-income products. It also provides flexibility regarding what to do with money once a Certificates of Deposit matures.
The CD Laddering Strategy
Certificates of Deposit (CDs) were at one time the cornerstone of fixed-income investing. While savings bank accounts paid a decent rate of return in the days before the United States Federal Reserve’s near zero interest rate policy began during the 2008/2009 financial crisis, Certificates of Deposit (CDs) always paid a better rate of return, especially Certificates of Deposit (CDs) that matured years out. With the zero interest rate policy in effect for many years a whole generation of investors have failed to gain an understanding of how to safely invest using Certificates of Deposit (CDs).
The CD laddering strategy is pretty simple, but it only works during times when interest rates are on the rise. With interest rates expected to rise, instead of investing all of your money into one Certificates of Deposit (CD) at one time, hold back and invest just a portion initially. Then, over a period of time, say every three months or six months, make additional investments in Certificates of Deposit (CDs). The idea is that over time, with interest rates on the rise, your investments in Certificates of Deposit (CDs) will yield higher rates of return.
For example, instead of investing $100,000 in Certificates of Deposit (CDs) when a five year Certificates of Deposit (CD) is paying 2%, invest just 20% or $20,000 initially. If the Federal Reserve aggressively raises interest rates, the next investment may be made three months later, when five year Certificates of Deposit (CD) is paying 2.5%. Continue investing every three months or when the Federal Reserve raises interest rates sufficiently. If you invested $100,000 in Certificates of Deposit (CDs) at five different times, 20% each time, as interest rates rise from 2% to 4% for five year Certificates of Deposit (CDs), you will be earning 3% once you are done investing, instead of 2%, if you had invested the money all up front.
Of course, the CD laddering strategy can be altered to take advantage of the anticipated interest rate environment or your own investment outlook. If interest rates are rising quickly and you need the money sooner than five years, you could make investments in Certificates of Deposit (CDs) faster in shorter maturing Certificates of Deposit (CDs). The point is that once you are averaged in, you will be earning a higher rate of return.
Another important part of the CD laddering strategy is the fact that the Certificates of Deposit (CDs) that you purchased at different time intervals will mature and pay back the principal invested at the same time intervals in the future. So, instead of having to deal with how to use or reinvest a large block of money all at once, you will have smaller blocks of money available to reinvest over a period of time. This can be useful if interest rates continue to rise, as you can roll over your Certificates of Deposit (CDs) investments into higher yielding Certificates of Deposit (CDs) rates over time. In other words, continue the CD laddering strategy. Or, you can figure out the best way to invest your money in the new economic climate, without committing all of your money all at once.
What To Know When Using The CD Ladder Strategy
There are some things that have to be understood about Certificates of Deposit (CDs) when using the CD laddering strategy. Certificates of Deposit (CDs) pay higher interest rates the longer you are willing to tie up your money in them. A Certificates of Deposit (CD) that matures in one year may pay just a fraction of what a Certificate of Deposit (CD) that matures in five years will pay. Make sure you purchase Certificates of Deposit (CDs) that make sense for your financial needs, since early withdraw from Certificates of Deposit (CDs) comes with penalties that could negate any gains. If you are unsure, err on the side of caution and buy Certificates of Deposit (CDs) that mature sooner rather than later.
The CD laddering strategy can only be utilized when interest rates are rising. There is no advantage to using it when interest rates are stabile, beyond the fact that your investments will mature at different times in the future. Utilizing the CD laddering strategy interest rates are falling or are expected to fall would have the opposite effect, as you would be averaging into Certificates of Deposit (CDs) at lower rate. Make sure that you keep your investments below the Federal Deposit Insurance Corporation (FDIC) threshold, so you do not lose your investment if a particular financial institution goes bankrupt. If necessary, split Certificate of Deposit (CD) investments among several financial institutions to remain below the FDIC threshold.