Building your ladder
A CD ladder can be as long or as short as you like, but for this example let's use a 5-year ladder with 5 rungs. If you have $20,000 to invest, you'd invest $4,000 in each rung. You could put $4,000 in a 1-year CD, $4,000 in a 2-year CD and continue on up to putting $4,000 in a 5-year CD.
After a year, the 1-year CD occupying the first rung matures and each of the other CDs has one less year until maturity. In other words, the 2-year CD now matures in 1 year; the 3-year is 2 years from maturity, etc.
The money from the 1-year CD that has just matured is rolled over into a new 5-year CD, since you no longer have a CD maturing in 5 years. Every year you're replacing the CD on the rung that's farthest out.
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 for 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.
Keep some liquid funds on the side
The most important thing to keep in mind when laddering CDs is to make sure the maturities match your cash needs. It's no good having a 1-year CD if you have an emergency halfway into the term and are in a cash crunch because your money is tied up. You won't want to tap into your CD because 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 1-year CD, you need enough cash on hand for one year of living expenses.
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While a 5-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. What this means is you could have a 1-year ladder with rungs every 3, 6, 9 and 12 months, for example.
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's CD laddering calculator.
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