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!