CD Ladder: Worth the Climb?

These days, CD laddering, like typewriter repair or steamboat captaining, is something of a lost art. Ultralow CD rates have meant that investors in America have pulled trillions of dollars out, even as the amount of cash sitting in more liquid savings accounts has skyrocketed.

"We're in a pretty low rate environment right now, so customers don't really see any incentive to lock in their balances for longer periods of time," says Wei Ke, a partner with Simon-Kucher and Partners, a global consulting firm that works with banks. "You're looking at these five-year CDs paying at 2 percent, 2.5 percent. That's pretty low for anything."

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CD Ladder: Worth the Climb?

Just because rates are low doesn't necessarily mean trashing your CD ladder and waiting for deposit rates to rise is the right answer, says Cary Guffey, CFP professional and CFP Board ambassador.

"I've been having this conversation with my clients for the past five years. Everybody says eventually they have to go up, and they're right. Eventually they will, but no one knows when and no one knows by how much," Guffey says.

What Guffey often hears from clients is: "I don't want to tie my money in case rates move up."

"The problem with that thinking is you have that opportunity cost," he says.

Staying short to wait for higher rates can cost you

Using real-world Bankrate data on average CD rates, let's find out what you would have earned with three different risk-free investing tactics over the past five years.

Scenario 1: You took one look at CD rates in October 2009 and put $10,000 in a money market account instead. Result: Over that period of time, money markets have averaged a 0.15 percent yield. So by October 2014, you would have made $77 in interest income.
Scenario 2: 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.
Scenario 3: 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. backing.

How laddering works

So how do CD ladders benefit savers?

"The way CDs work typically is you're paid more for the length of time that you're tying the money up," Guffey says.

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.

"Assuming the theory holds that the longer you're tying up your money in that timed deposit, the more you're compensated for that, you should make more by having that ladder than if you just did a one-year CD," Guffey says.

Unfortunately, the difference in yield between a one-year CD and a five-year CD isn't nearly as large as it used to be, somewhat diminishing the benefits of laddering, Guffey says.

You can make 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 out with a one-year CD, 18-month CD, 24-month CD and 30-month CD. These may seem like weird maturities, but they are available.

A hedge against unpredictable rates

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.

Laddering lies somewhere between those two extremes of very liquid (putting everything in a low-paying money market account or a short-term CD) and not at all liquid (putting everything in a long-term CD) because you're regularly getting cash you could reinvest at higher rates should interest rates improve, Guffey says.

"Certainly, making more money on your money and building in liquidity features is a good idea," Guffey says.

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 rise and leave your low-rate CDs behind.

On the other hand, longer ladders may be considered more aggressive because longer maturities mean you bear a greater risk of falling behind as interest rates rise.

Rate outlook: More flatness to come?

It seems like forever since we've seen decent yields for savers, but rising rates may yet be further off.

The Federal Reserve isn't likely to boost rates this year or for a long period next year, Simon-Kucher's Ke says.

"The best guess I can give you right now is nothing's going to change until the end of 2015," says Ke.

Even after the Fed acts, it can take a while for deposit rates to catch up.

"There's typically a lag between the federal funds rate movement and the actual deposit rate movement," says Ke. That lag can range from a month to as long as two months for larger banking institutions.

"The question is whether this movement is going to be quick," Ke says. "If the economy improves sufficiently -- from not just a U.S. standpoint but globally -- and that justifies moving the rates up, then I can see one situation where the rates move up quite rapidly in the first quarter of 2016."