With CD rates near historic lows, the long-popular strategy of "laddering" has been left on shaky ground.
As a tool used to balance the safety of a certificate of deposit with the need for liquidity and the highest available interest rate, a CD ladder has long been a popular way to seek safety and hedge against interest rate volatility.
But consumers are finding little attraction to CDs these days. Throw in the fact that interest rates are likely to rise once the economy starts to recover and one has to question whether it's a good idea to lock up money in a five-year CD at a paltry rate of less than 3 percent.
Laddering CDs is buying a series of CDs with incremental maturity dates. For instance, a person might invest $50,000 by buying 10 CDs with maturity dates every six months. Each CD acts as a rung on the ladder and as each CD matures, the money is reinvested in a long-term CD, typically five years. The proceeds are then reinvested into more long-term CDs, but as each maturity date arrives, the holder of the CD ladder has the opportunity to put those funds into higher yielding CDs or access the cash penalty-free if need be.
Beth Gamel, CPA/PFS, executive vice president of Pillar Financial Advisors in Waltham, Mass., says people typically choose CD laddering if they want a higher return than their money market account but still have a need for the liquidity. In a typical market, CD holders are rewarded with higher returns for the longer terms. The interest is essentially paying them for the loss of liquidity, so the longer the time period, the higher the return. However, keep in mind that returns on CDs have shrunken significantly and there isn't much more of a return for locking in at a longer period.
"There is not a lot of excess yield for going out very far right now. The difference between six months and a year might be 0.3 percent. You really want a fairly meaningful difference between rates at each point," says Gamel.
At year's end 2009, the average yield on a one-year CD was 1.69 percent while the yield on a five-year CD was 2.94 percent. Gamel says to lose that liquidity for five years at today's rates might not be the best option, especially considering that interest rates will likely rise when the economy starts to rebound. Gamel does not suggest going out more than two years in today's CD market.