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Why a CD Ladder Strategy Makes Sense Now


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What Is a CD Ladder? | An Explanation

CD LadderIn the current economic environment in which interest rates are expected to rise for several years, a CD ladder strategy makes a lot of sense.  Certificates of Deposit (CDs) have been a popular investment vehicle for many years, due to their fixed guaranteed rates of return and fixed maturity dates.  In recent years, CD yields have been extremely low, as the United States Federal Reserve has pursued a near zero percent short-term interest rate policy, which has provided banks access to very inexpensive capital for their lending needs.  Additionally, a lack robust demand for consumer and business loans has lessened the need for banks to raise money by selling CDs to investors.  That and the relatively low interest rates charged by banks for consumer and business loans has kept the yields that banks are willing to pay buyers of their CDs extremely low since the 2008/2009 financial crisis.

With the Federal Reserve expected to eventually raise short-term interest rates and economic growth expected to accelerate in coming years, CD yields are expected to increase over the next several years.  A CD ladder strategy provides the best way to maximize returns on CD investments as interest rates and CD yields rise.  This is because by its design, a CD ladder strategy will capture higher CD yields as they become available over time.

A CD ladder is an investment strategy in which investments in CDs are done at periodic time intervals rather than all at once.  For example, if an investor has $100,000 to invest in CDs, rather than investing the entire $100,000 in a five year CD that currently pays a 2% annual interest yield, an investor that pursues a CD ladder investment strategy would invest the $100,000 in CDs in stages over a selected time period.  If interest rates are expected to rise for the next two years, an investor may stagger CD investments every six months until the entire $100,000 has been invested in CDs to capture higher yielding CDs as interest rates rise over time.  For example, an investor using the CD ladder investment strategy could invest $25,000 every six months in CDs with five year maturities until the entire $100,000 has been invested.  If interest rates rise from 2% to 4% over the two year time period, then they will have averaged into five year maturity CDs that have an 3% average yield, instead of committing all of their money initially when five year maturity CDs were yielding 2%.
CD Laddering.
It should be noted that any time interval can be used when implementing a CD ladder strategy.  If an investor is anxious to invest their money, they could shorten the timeframe in which the CD investments are made.  Also, if an investor does not want to tie up their money in CDs for a long period of time, they could invest in shorter duration CDs, as CDs are available with maturities that range from three months to ten years.  Just keep in mind that the longer that CDs take to mature, the higher the yields.  To capture the highest yielding CDs, longer duration CDs should be purchased.

Cashing in a CD before its maturity date will often result in penalties by the issuer of the CD.  These early-withdrawal penalties are usually clearly spelled out in the CD purchase agreement.  If they are not, then make sure you understand them before investing in a CD.  If you may need the money invested in a CD before the CD is scheduled to mature, it is better to buy a shorter duration CD or just keep the money in a more liquid interest bearing account, such as a savings account or a money market account.

The Advantages of Using a CD Ladder Strategy

CD Ladder InvestmentUsing a CD ladder strategy has several advantages during times when interest rates are rising, compared to simply investing an entire sum of money in CDs at one time.  First off, as interest rates rise and CD yields paid by banks rise, the CD ladder strategy allows an investor to average into CDs at higher yields.  Secondly, since the CDs are purchased at staggered time intervals, they will mature at staggered time intervals in the future, freeing up cash for either reinvestment in CDs at even higher yields (if interest rates continue to rise) or for other investments that make sense in a future economic environment.

When Not To Use a CD Ladder Strategy and Ways To Protect CD Investments

The CD ladder strategy does not make sense during times when interest rates are falling or are expected to fall, such as at the onset of an economic recession or towards the end of a strong period of economic growth.  This is because investors interested in investing their money in CDs would capture the best CD yields and rates of return by simply investing their whole sum of money into CDs and locking in high interest rates before they fall.  Laddering into CDs as interest rates fall would mean a lower average yield from CDs that are purchased, and therefore is a counterproductive strategy to pursue.

Since banks are prone to failure, which can affect investor deposits, including CDs, it is vitally important that investors purchase CDs from FDIC-insured banks and that they do not exceed the maxim insured amount when they make a CD investment.  Investors with large amounts of money to invest in CDs often spread their CD investments across a number of FDIC-insured banks to protect against a default at any single lending institution and to ensure that their CD holdings are below the $250,000 FDIC insurance threshold.  For example, if an investor has $1 Million to invest in CDs, to protect their CD investments, they would invest $250,000 in CDs sold by four separate banks to keep their investments below the $250,000 FDIC insurance threshold.

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