Creating a CD Ladder

How to maximize earnings and maintain liquidity 

 The process of creating a CD ladder is a simple way to help keep your assets liquid enough to cover the unexpected but secure at the same time. CDs, Certificates of Deposit are time deposits offered by most banks. They are covered by FDIC insurance up to the current limits of $250,000 per account. Please visit the FDIC website for the latest news concerning coverage amounts and limitations - FDIC. Recently Cd rates have been under pressure as the Fed continues to pump money into the system to spur business activity and employment. The best cd rates available are for longer terms.

Certificate of Deposit accounts are typically offered for short terms of 3, 6, or 9 months. Many investors prefer the longer terms of 1-5 years. This is because the longer terms provide a higher return. Speaking of return, the individual investor should be aware of the difference between APR(rate) and APY (annual percentage yield). This is a function of compounding. As one might expect with many banks offering CDs the terms are all slightly different. Simply put, the more often the interest is compounded, the higher the APY will be. So watch for banks offering CDs that are compounded daily or weekly versus monthly or quarterly. Every little bit helps in earning a better return on your invested funds.

The Laddering process can be very simple or more involved depending on your own requirements. First, let's start with a very easy example. Presume that you have $30,000 to work with and that you want at least $10,000 to mature annually. (See the discussion below regarding liquidity and penalties for early withdrawal of funds). You would take $10,000 and deposit with your bank for 1, 2 and 3 year terms - $10,000 per year for 3 years. As each year matures, you would reinvest that amount for a 3 year term.

Now for a more sophisticated investor with a much larger nest-egg you can do the same thing annually for out to 5 years or monthly for 1-60 months. The advantage of placing your funds in a monthly laddering plan is that you know that every month you will have funds available if needed. Another benefit of the CD ladder is that if rate environment changes from a low one (like now) to a higher one the ladder will fill in with the higher rates over time.

One important reason for using a CD Ladder is to work around the issue of penalties for early withdrawal of funds from a Certificate of Deposit. Banks charge a penalty because of the costs they incur replacing the funds lost to withdrawals - and it can add up. The typical penalty on a 12 month CD is 180 days interest. The liquidity provided by laddering reduces the possibility that you will be subject to these costs.

Following is a an example of how to start a ladder with 1-5 year CDs with a starting balance of $10,000 in each term:

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Do you want to increase your savings? See Twenty-Five Ways to Save to learn how.

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