Will a CD ladder really earn you money?

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Young man standing behind ladder | Westend61/Getty Images

Westend61/Getty Images

CD laddering may seem like a financial move from a bygone era, but it can still be a smart move for savers. And despite the Federal Reserve's quarter-point uptick of the federal funds rate last December, low CD rates over the past several years have left investors seeking other, more liquid savings accounts.

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Laddering can still help savers

Just because rates are low doesn't mean you should trash your CD ladder and wait for deposit rates to rise further, says Cary Guffey, CFP professional and CFP Board ambassador.

"I've been having this conversation with my clients for the past 5 years. Everybody says eventually they have to go up, and they're right. Eventually they will, but no one knows when and no one knows by how much," Guffey says.

Guffey often hears this concern from clients: "I don't want to tie up my money in case rates move up."

"The problem with that thinking is you have that opportunity cost," he says.

Staying short to wait for higher rates can cost you

Using real-world Bankrate data on average CD rates, let's find out what you would have earned with 3 different risk-free investing tactics during the time when interest rates were at rock bottom, starting with the recession and going out 5 years.

  • Scenario 1: You took one look at CD rates in October 2009 and put $10,000 in a money market account instead.
    Result: Over that period of time, money markets averaged a 0.15% yield. So by October 2014, you would have made $77 in interest income.
  • Scenario 2: You wanted to stay liquid in case rates increased, so you invested $10,000 in 1-year CDs and rolled them over every year.
    Result: $241.14 in interest income.
  • Scenario 3: You started a 5-year, $10,000 CD ladder, reinvesting at the new averages as those CDs came due.
    Result: $729 in interest income.

As you can see, no one's getting rich here, but $729 is a lot more than $77, especially when all the investments in question have the same Federal Deposit Insurance Corp. backing.

How laddering works

So how do CD ladders benefit savers?

How CD laddering works | Cartoon © Ziven/

"The way CDs work typically is you're paid more for the length of time that you're tying the money up," Guffey says.

Once it gets established, CD laddering lets you earn the higher yields offered on those longer-term CDs while still having cash in hand as the older "rungs" of the ladder mature.

"Assuming the theory holds that the longer you're tying up your money in that timed deposit, the more you're compensated for that, you should make more by having that ladder than if you just did a 1-year CD," Guffey says.

Unfortunately, the difference in yield between a 1-year CD and a 5-year CD isn't nearly as large as it used to be, somewhat diminishing the benefits of laddering, Guffey says.

You can make a ladder as long or as short as you like. For instance, you could shorten it by buying a 6-month CD as the "bottom rung" and finish it out with a 1-year CD, 18-month CD, 24-month CD and 30-month CD. These may seem like weird maturities, but they are available.

A hedge against unpredictable rates

While no one wants to be "long and wrong" -- stuck with low yields on long-term investments as you helplessly watch interest rates rise -- you're clearly giving something up by staying out of longer-term maturities altogether.

Laddering lies somewhere between those 2 extremes of very liquid (putting everything in a low-paying money market account or a short-term CD) and not at all liquid (putting everything in a long-term CD) because you're regularly getting cash you could reinvest at higher rates as interest rates improve, Guffey says.

"Certainly, making more money on your money and building in liquidity features is a good idea," Guffey says.

If you decide to ladder, adjusting the length can help manage interest rate risk. A short ladder could be construed as more "conservative" because the shorter maturities you're buying mean you're bearing less risk that interest rates will rise and leave your low-rate CDs behind.

On the other hand, longer ladders may be considered more aggressive because longer maturities mean you bear a greater risk of falling behind as interest rates rise.

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