CD laddering may seem like a financial move from a bygone era, but it can still be a smart strategy for savers. It can be especially useful in a rising-rate environment. If you’re looking for a low-risk investment but want to take advantage of rising rates, CD ladders are worth consideration.
Laddering can help savers
Anytime is a good time to build a CD ladder, says Jill Schlesinger, senior CFP board ambassador and certified financial planner.
“If you’re the kind of person who does not like volatility, then don’t let the market talk you into assuming risk,” Schlesigner says.
As fixed-rate, fixed-term financial products, CDs are inherently low- to no-risk propositions. CD laddering allows you to gain access to your money in set intervals and either reinvest or use that cash for something else.
Whether you simply don’t like risk or you’re in a situation where you know you’re going to need to access money within a certain time frame, a CD ladder can be a good option, Schlesinger says.
Staying short to wait for higher rates can cost you
Using Bankrate data on average CD rates, let’s discover what you would have earned with three different risk-free investing strategies during the time when interest rates were at their lower level, beginning with the recession and going out five years.
1. Scenario one
You took one look at CD rates in October 2009 and put $10,000 in a money market account.
Result: Over that period of time, money markets averaged a 0.15 percent yield. So, by October 2014, you would have made $77 in interest income.
2. Scenario two
You wanted to stay liquid in case rates increased, so you invested $10,000 in one-year CDs and rolled them over every year.
Result: $241.14 in interest income.
3. Scenario three
You started a five-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. coverage.
In a higher-rate environment, like the current one, this strategy could be even more beneficial.
How laddering works
So how do CD ladders benefit savers?
CD laddering is a strategy that uses multiple CDs maturing at different intervals to take advantage of higher interest rates.
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.
You can create a ladder as long or as short as you like. For instance, you could shorten it by buying a six-month CD as the “bottom rung” and finish it with a one-year CD, 18-month CD, 24-month CD and 30-month CD. These may seem like odd maturities, but they are available.
A hedge against unpredictable rates
When it comes to CD ladders, one commonly held concern is that you’re tying up money while rates move higher.
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.
Rising-rate environments may make the case even stronger for CD laddering.
If rates don’t go up as much as you think, for example, you’ll know that you’ll probably end up better off for taking a slow and steady approach, Schlesinger says.
Of course, it’s impossible to know where the top of the rate cycle is or time the market.
“The beauty of a CD ladder is that you don’t have to get your timing perfectly right,” Schlesinger says.
“You don’t have a shot at second-guessing yourself with a CD ladder,” she says. “If you’re in a rising interest rate environment and waiting for the perfect time to lock in a CD, you may be vulnerable to the emotional whims that can derail a plan.”
CD ladders can hedge against that vulnerability.
Overall, a CD ladder can be part of a larger financial plan, Schlesinger says, constituting the lower-risk end of the fixed portion of your portfolio.
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 increase and leave your low-rate CDs behind.
On the other hand, longer ladders may be considered more aggressive because longer maturities mean you carry a greater risk of falling behind as interest rates rise.
Be wary as CDs mature
One thing to keep in mind when purchasing CDs from banks is that they may not always have your best interest in mind.
Schlesinger says to be careful as CDs mature, because often banks have very aggressive sales tactics and may try to suggest you talk to someone who isn’t actually a certified financial planner. Knowing you have money in hand from your freshly matured CD, these sales people for the bank may try to sell you something you don’t want, like a loaded mutual fund or a variable or fixed annuity.