Why build a CD ladder?

Don Taylorq_v2.gifDear Dr. Don,
I've read all the articles about laddering, but I still don't understand why laddering is more beneficial than putting all the money in a five-year CD (certificate of deposit). I have about $6,000 dollars that I want to save wisely. I would appreciate it if you could explain why laddering CDs makes sense just one more time. Thank you.
-- Ayako Accumulate

a_v2.gifDear Ayako,
A CD ladder forces you to reinvest periodically. That forced reinvestment stops you from trying to time the market. Building a CD ladder requires you to invest in several maturities out to the longest maturity on your investment horizon. The individual CDs are rungs on the ladder. When one matures, you reinvest the money out to your investment horizon.

If you build a five-year ladder with one-year rungs, when the one-year CD matures you would use the money to buy a new five-year CD. That means that every year you would buy a five-year CD when an existing CD matures. When interest rates are low, you get a lower yield; when they're high you get a higher yield, but your average yield is expected to outpace what you could do by trying to time the market.

It's a little bit like dollar cost averaging in stocks, only with dollar cost averaging you invest a set amount, say $200, on a regular interval and the number of shares that you can buy with that $200 varies with the price of the stock.

The big difference between dollar cost averaging and a CD ladder is that with a CD ladder, you invest the money initially and then reinvest periodically. With dollar cost averaging, you invest periodically, building the principal balance in the account.

No one likes to be "long and wrong" with interest rates. You want to avoid buying a five-year CD for $6,000 today at 3.25 percent only to see CD rates rise over the term of the CD.

The temptation to time interest rates is strong, especially in the current low interest rate environment. If you're convinced that rates are heading higher, you may want to invest in a stepladder CD portfolio, where you keep your investment horizon and maximum maturity shorter initially, and then extend the rungs of the ladder as your CDs mature.

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