By Dr. James M. Dahle, WCI Founder
As interest rates rise and markets fall, investors are expressing more interest in safe investments, especially investments that do not decrease in value with rising interest rates—like bonds. It is no surprise to see rising search traffic about Certificates of Deposit (CDs). However, before investing in CDs or attempting to ladder them, you need to really understand their pros and cons.
What Is a CD Ladder?
A CD is a cash investment, like a savings account or money market fund, and it has the main benefit of a cash investment: it will never lose principal due to market or interest rate fluctuations. A CD is simply a savings account with a term. Terms typically range from six months to 10 years, and while you can usually access your principal even if you withdraw your money before the end of the term, you usually pay a penalty such as 3-6 months of forfeited interest to do so. Due to this additional restriction, a CD will typically pay more than a savings account at the same institution. The longer the term, the higher the interest rate the CD will pay.
A CD ladder is simply a collection of CDs with different maturity dates. If you had CDs that matured in one year, two years, three years, four years, and five years, you could say you had a “five-year CD ladder.”
Why Would Someone Ladder CDs?
The benefit of a ladder, at least a “fully mature” ladder, is that you are earning the interest rate for a five- or 10-year CD while still having access to some of your money every year penalty-free. When interest rates drop, you are still earning the previously higher interest rate with most of your money. When interest rates rise, there is no hit to your principal, unlike with a bond fund or individual bonds (in the event you have to sell them prior to maturity).
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How Do You Build a CD Ladder?
There are two ways to build a CD ladder. The first is to put the same amount of money into a five or 10-year CD every year. After five or 10 years, respectively, of doing this, you will have a collection of one-, two-, three-, four-, and five-year (or one- to 10-year) CDs, each paying you the rate of a five- (or 10-) year CD—or at least what the rates were at the time of purchase.
The second method of building a CD ladder, which works much better for the impatient, is to buy all of the CDs at once. For example, if you had $100,000 you wanted to invest into a 10-year CD ladder, you would put $10,000 into a 10-year CD, $10,000 into a nine-year CD, $10,000 into an eight-year CD, and so on down to $10,000 in a one-year CD.
Obviously, the first method will pay a higher average interest rate (assuming no changes in interest rates over those years), but it also takes much longer to build. Either way, assuming you want to continue the ladder, you roll the maturing CD into a new five- or 10-year CD.
What Can You Use a CD Ladder For?
A CD ladder has two uses. The first is an ongoing investment. You simply continue to roll those maturing CDs into new ones. In fact, you may even purchase a larger CD each year using new money in your portfolio. Perhaps you start with $10,000 in each CD, and after a decade or two, perhaps you have $100,000 in each CD.
The second use is to match future liabilities. For example, if you are planning to spend $100,000 per year, perhaps you buy a $500,000 five-year CD ladder. As the ladders mature, that provides income to live off for the next year. Each year, you then take $100,000 out of the remaining portfolio and buy another $100,000 five-year CD.
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Are CDs Insured?
CDs are generally issued by banks or credit unions, and they qualify for FDIC (banks) or NCUA (credit union) insurance. This insurance is limited to $250,000 per depositor, per bank. Buying five different CDs in your name at the same bank does not give you five separate $250,000 limits. They all share the same $250,000 limit. However, there are times (such as the Silicon Valley Bank meltdown in March 2023) when the federal government insured deposits above and beyond $250,000.
Even if you purchase a CD via a broker, it still qualifies for FDIC/NCUA insurance depending on the original issuing institution. Be aware that there are “CD-like” investments out there that pay a fixed rate for a specified time period. These may be issued by a real estate investment company or other institution. These are not CDs and do not qualify for FDIC/NCUA insurance, although they generally offer a higher interest rate to compensate for the higher risk.
Which Is Better: CDs or a Savings Account?
CDs generally pay a higher interest rate, so if you're sure the money will be in the account for the entire term, you're generally better off with a CD. However, if interest rates are rising rapidly, you could come out behind with a CD. For example: if you bought a five-year CD that pays 4% while savings accounts were paying 3% but then short-term interest rates rapidly increased to 6%, you would have been better off with the savings account. Some banks issue CDs that allow you to “update” your interest rate once or more during the term to help protect against this possibility. If interest rates really rise rapidly, it may be worth forfeiting the interest penalty in order to swap into a CD paying a higher interest rate.
If interest rates fall, you will be much better off with a CD than a savings account since that CD will still be paying that higher interest rate.
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How Is a CD Ladder Different from a Bond Ladder?
Investors can also construct a bond ladder in a similar way to a CD ladder. This is generally done using individual bonds, usually Treasuries (either nominal or inflation-indexed) to minimize default risk. If the Treasuries are held to maturity, they function exactly like CDs, and one can choose between Treasuries and CDs simply based on which is paying more in interest. However, CD ladders and bond ladders differ when they are not held to maturity. When a CD is closed or canceled before maturity, the investor pays a penalty in the form of losing a few months of interest. When a bond is sold prior to maturity, it can be sold with either a gain or a loss. If interest rates have risen since it was issued, it is sold at a loss. If interest rates have fallen since its issue, it will be sold with a gain. That gain will be taxed at long-term capital gains rates if the bond was held for longer than one year.
Is Now the Right Time to Buy CDs?
Unfortunately, the answer to this question is partially unknown (and unknowable), because it depends on future interest rate movements. If interest rates rise, you would be better off with a savings account or, more likely, a money market fund. If interest rates fall, you would be better off with a bond or bond fund. It also depends on whether you might need the money before the term is up. But if you want an investment that will not lose principal even if rates go up and that will pay more than a savings account if rates stay the same or go down, a CD will fit that bill. Building a ladder of CDs can help you match future liabilities or just earn you a little more interest than buying shorter-term CDs.
What Is the Best Strategy for Laddering CDs?
If you are trying to match liabilities, you can build a CD ladder out to as long as 10 years. It is hard to buy CDs for much longer than that. In fact, CDs longer than five years can be difficult to find at competitive rates. If you are just trying to eke out a little more interest on your cash than you can get in a savings account while preserving some liquidity, a five-year ladder should be adequate. If you are concerned rates are going to drop, you can “lock in” today's rates for years by purchasing a five-year or even longer CD. However, if you're 100% sure rates will drop, you would be better off buying long-term Treasury bonds.
What do you think? Do you invest in CDs? Why or why not? Do you ladder them? If so, what does your ladder look like? Comment below!
With regard to the shorter CDs (6 months, 1 year), I think Treasury Bonds are better in comparison since you don’t pay state and local taxes on the interest.
I would tend to agree. Further, I would think the credit quality of a Treasury Bond would have to be considered significantly higher than that of a CD, right (i.e. less credit/default/etc. risk)?
Not if you’re under $250K. Same thing (US government) backing both.
Right. Good point. Thank you.
Unless you live in one of the nine states with no state income tax (Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming). Then you should consider only the rates.
At WCICON23, there was a discussion of using MYGAs as “rungs” of the CD/MYGA ladder, especially if you were going to SPIAtize the money anyway. So, instead of using “good” differed annuities (DIAs), you can use MYGAs, and tax-free exchange them into SPIAs if you want the income. This blog doesn’t have current MYGA or CD rates but talks about the advantages/disadvantages of using MYGAs in a CD ladder. https://www.fiphysician.com/multi-year-guarantee-annuities-mygas-as-buffer-assets/
That’s exactly the right comparison. MYGAs are a CD alternative.
For a few years I had a bond mutual fund and considered that part of my cash if needed- not so much emergency fund but future expected costs as below. However, following Andrew Tobias’s advice in The Only Investment Guide You’ll Ever Need not to invest in things I don’t fully understand and realizing in the last few years that any bond fund may indeed have less money than I put in it at any point I wanted to tap it for cash, I decided to use CDs in place of the ‘bond’ portion of our portfolio. (Again, if I were certain we’d never tap them early, individually held bonds would address this, but my Luddism plus still changing situation means I don’t think it’s worth the effort involved.)
Since I am still unable to answer husband’s query of “How much do we actually spend every month?” (we have been changing situations and buying big stuff past few years), I instead calculated how much we can AFFORD to spend every month. (If we live to 95 and second calculation if I am widowed very soon, lowering monthly pension income.) I am working on making a 5 year CD ladder that kicks out the higher amount (when added to regular monthly income) every month, knowing that some months I’ll roll it over and some months we’ll spend it all, though most likely eg when we get a new car it’ll be all the CDs maturing over a few months- saved up or closed early depending on the urgency of the purchase. I find the argument that savings at X+1% is better than CDs at X% inaccurate- I think Jim has explained it but not hard hittingly enough for my preference: with the CD I get X% for the next Y years, but savings I get X+1% for possible ONLY THE NEXT FEW DAYS and perhaps only 0.5 or 1% average over Y years time. (Of course I lose the chance- without paying an early closure ‘fine’- to perhaps ((but probably not over 3-5 years)) earn even more than X+1% over Y years in the non CD account.)
Retired, and semi-Luddite- I DO buy I bonds online and have most of our portfolio at Vanguard, but otherwise have not bothered to buy CDs or individual bonds from any bank or group I have never set foot in. Worry even more after the bank troubles now, and every time a friend (and sometimes one who works there!) relates about an embezzler at our local credit union (CU), that my decent rates for CDs might be my credit union being foolish but now MIL has moved her money (husband joint with her) from there our family money there is fully covered by NCUA (like FDIC but for CUs).
Even prior to retirement I kept CDs for short term possible expenses- potential (1 down, 1 to go) kid’s weddings, their college costs (done!), and the new cars I promised them (one each, and again 1 to go).
My big retiree problem is to take money out of stock funds etc. for building and replenishing the not yet full 5 year CD ladder. I find myself timing the market saying “I’ll just wait until the stocks are closer to their 52 week high than they are now.” I am getting ready to force (on myself) a monthly or at least quarterly withdrawal from Vanguard but keep finding excuses (mostly tax consequences since still converting things to Roth, timing those for possible market lows when I notice them) to put it off. Which could lead to me having to sell stocks at a very bad time if one month or year we need a new car for us, and for the kid who is also getting married just then, plus maybe a home repair or two.
Why would I buy a CD or MYGA with all the layers of taxes, fees and restrictions? My Vanguard Federal MMF is paying >4.5% and State tax free. If rates go up, I am immediately rewarded with higher rates. Minimal fees, no restrictions and backed up by the US Treasury.
What’s the ticker for this one and what is the Schwab equivalent?
SWVXX – Schwab Value Advantage Money Fund – Investor Shares
https://www.schwabassetmanagement.com/products/swvxx
Here’s the Vanguard one:
https://investor.vanguard.com/investment-products/mutual-funds/profile/vmfxx
VMFXX. That’s where my cash is sitting right now.
VMFXX – the commenter above says that is exempt from state and local tax. I’m getting conflicting info on Google can someone confirm or deny this?
Some of VMFXX is exempt from local/state. If you really want that, go with the treasury MMF instead of the federal one as it is all exempt from local/state.
Found it!
https://invest.ameritrade.com/grid/p/site#r=jPage/https://research.ameritrade.com/grid/wwws/mutualfunds/profile/profile.asp?symbol=SWVXX&c_name=invest_VENDOR
It has an expense ratio of 0.35
Is it still worth it?
Thanks!
Only you can make that decision. Would you be satisfied with the current (3/24/2023) yield of 4.58%, which is net of expense ratio? (See current yield here: https://www.schwab.com/money-market-funds )
MMFs tend to have a little higher expense ratios due to the high turnover. The yield is after the ER and you can pick these things mostly by yield and convenience.
Because you think short term rates are going down soon and you want to “lock in” the rate you can get now. Or you think rates are going to stay the same and it’s worth the hassle to get an extra little bit.
i use the vanguard treasury money market. all treasury bills,liquid,safe. yield almost 5 percent now
My wife and I are new in our career and do travel physical therapy. We plan to do this temporarily (~6 more months) and then buy a house. We use CD’s because of how safe and guaranteed they are and we are certain the money will stay in there until a predetermined date.
“However, CD ladders and bond ladders differ when they are not held to maturity. When a CD is closed or canceled before maturity, the investor pays a penalty in the form of losing a few months of interest.”
Not necessarily. Brokered CDs can usually be sold on the secondary market before maturity which can result in a net loss (if interest rates rise) or a net profit (if rates fall).
Over the last few weeks I sold an intermediate bond fund that was still way down due to rising interest rates and put the proceeds into a 5 year CD ladder (bought through Fidelity) yielding around 5%. I am at the point where I will begin withdrawing money from my IRAs. Along with expected dividends from my other investments in the IRAs, I should be able to fund about 9 years of needed distributions (including expected RMDs in 4 years) to supplement my other sources of income. I feel good about the decision given the certainty of CDs with FDIC protection at 5% (which is more than I would expect from intermediate bonds). Maybe I could make more through other options, but I like the current interest rates and can match up my “liabilities” with sources that won’t lose principal.
Great article Jim! With the current market fluctuations and rising interest rates, it’s crucial to explore safe investment options like laddering CDs. It’s a fantastic way to maintain liquidity while also earning higher interest rates.
I appreciate how you laid out the two methods for building a CD ladder and the various uses for them. Matching future liabilities or using them as an ongoing investment seem like excellent strategies.
One question I have is whether you recommend any specific online banks or institutions for purchasing CDs, considering factors like competitive interest rates and customer service? It would be helpful to know which platforms are trustworthy and offer the best deals.
Overall, this post provides valuable insights into CD laddering, especially for those looking to diversify their investment portfolios in a low-risk manner. Thanks for sharing your expertise!
You can buy them at Vanguard or Fidelity from multiple different banks. Otherwise, I’d probably only look at the banks I already had a relationship with. I’ve never actually owned a CD though to be honest.
I like Bankrate.com it has lots of information on current rates, terms, etc. for all types of banking needs.
I like the rates and liquidity of MM funds (but I own a CD- my first one ever!)