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Savvy investors keep a portion of their portfolio
in fixed-income investments where it's not subject to the ups and
downs of the stock market. Many people opt for the rock-solid security
of certificates of deposit, or CDs, but you don't necessarily want
to go to the bank and simply buy a handful of CDs. Having a strategy
can lead to bigger returns.
Strategy laddering
Interest rates rise and fall, but in a fairly slow
manner. If the economy is in a slump and interest rates are in a
prolonged low-rate cycle, you don't want to get stuck buying a bunch
of long-term CDs with low interest rates.
Laddering CDs can help you beat lengthy low-rate cycles
because it allows you to take advantage of interest rates spread
over months or years while keeping some liquidity. Laddering takes
advantage of the fact that almost always, the highest interest rates
are paid to the longest term CDs. In other words, a five-year CD
is almost always going to have a higher rate than a one-year CD.
A CD ladder can be as long or as short as you like,
but for this example let's use a five-year ladder with five rungs.
If you have $20,000 to invest, you'd invest $4,000 in each rung.
You could put $4,000 in a one-year CD, $4,000 in a two-year CD and
continue up to $4,000 in a five-year CD.
After a year, the one-year CD occupying the first
rung matures and each of the other CDs has one less year until maturity.
In other words, the two-year CD now matures in one-year; the three-year
is two years from maturity, etc.
The money from the one-year CD that has just matured
is rolled over into the now vacant five-year rung. Every year you're
replacing the rung that's farthest out -- in this case the five-year
rung.
By always replacing the longest maturity, which is
the top rung on the ladder, you're always reaping the benefit of
earning the highest interest rates. If interest rates happen to
be in a slump one year, you're only reinvesting a portion of your
investment when yields are low. And you don't have to try to guess
when rates are at their highest because you're constantly reinvesting.
The most important thing to keep in mind when laddering
CDs is to make sure the maturities jibe with your cash needs. It's
no good having a one-year CD if you have an emergency halfway into
the term and are in a cash crunch because your money is tied up.
Penalties for early withdrawal will squash your returns. Make sure
there's enough cash in your emergency fund to carry you through
until the shortest rung on your ladder matures. In other words,
if the first rung is a one-year CD, you need enough cash on hand
for one year of living expenses.
While a five-year ladder allows you to take advantage
of the best interest rates offered, your ladder could be shorter
if it makes you more comfortable. The rungs should be whatever maturities
suit your cash flow needs.
In an extremely low-rate environment, it's best to
keep a ladder short. In that scenario, you could have a one-year
ladder with rungs every three, six, nine and 12 months.
One caveat, it's not a good idea to use callable CDs
in a ladder. If interest rates drop, your whole ladder, or a portion
of it, could be called.
Try your hand at laddering and see what your returns
will be with Bankrate.com's CD
laddering calculator.
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Chapter 2: Certificates of deposit
