What is a CD Ladder?
I first heard the term CD Ladder several years ago while listening to a Saturday morning radio show that dealt with topics like mutual funds, annuities and estate planning.
Most of you are familiar with a Certificate of Deposit. CD’s are investment vehicles, generally offered by banks where an amount of money is invested for a set period of time at a set rate of return. There is a fair amount of variation on CD terms, however the basics stay the same: a guaranteed rate of return for a set period of time and the investor cannot access the money until the CD matures. Banks often offer better rates of return on CD’s because they know exactly how long they will be in possession of the money, while savings account interest rates are lower because the investor can take the money out of the bank at any time. One good source of current CD rates can be found at Bank Rate.
CD’s have two major advantages: your money is safe, FDIC insured, you are protected against losing your investment and the higher-than-savings-account guaranteed rate of return. CD rates vary according to the length of time specified in the CD terms – the longer the term, the higher the rate. The point is that the length of time and the rate of return are locked in, they cannot change and they provide the structure for the concept of a CD Ladder.
A CD Ladder is set up when a person purchases a large number of smaller CD’s rather than placing all of their working capital in a single CD. Here is a possible scenario using a balance of $10,000:
- CD #1 $2000 for six months at .75%
- CD #2 $2000 for 12 months at 1.10%
- CD #3 $2000 for 18 months at 1.37%
- CD #4 $2000 for 24 months at 1.69%
- CD #5 $2000 for 30 months at 2.01%
I’m totally pulling numbers out of the air here, but the concept is that you will be able to receive income at regular intervals, while still earning the highest rate possible with the rest of your capital. Obviously, you can adjust the amounts and intervals to fit your situation. In these days characterized by stock market volatility and a lack of job security CD’s might be the best way to earn passive income with as little risk as possible.
Individuals with the following characteristics are the most likely to benefit from a CD Ladder:
- Individuals nearing retirement who do not need stock market returns and who cannot risk losing capital.
- Individuals with large amounts of liquid capital.
- Individuals who do not need a lot of money to live (i.e. low debt, low expenses, no dependents, etc.)
The most important thing to remember about CD’s is that while they are low risk, you will not be able to touch that cash for a period of time. This means only open a CD with money that you can live without for some time. CD’s do offer early withdrawal, but usually there is a significant penalty and the chance that you will not collect any interest.
Article by Stew
Photo by Robert S. Donovan