Can using a CD ladder strategy keep your assets more liquid?
To create a CD ladder, you invest your savings in CDs with varying maturities and interest rates
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The financial strategy of creating a CD ladder may promote liquidity in your portfolio.
"Laddering CDs — meaning, purchasing CDs with varying maturities, say in one month, three months, six months and a year — can be a powerful way to grow a cash base for money where you’d like a little bit of extra return above an interest-bearing checking or savings account but don’t need the money for an expense today," said Rob Williams.
Williams is managing director of financial planning, retirement income and wealth management at the Schwab Center for Financial Research.
THE PROS AND CONS OF LIQUIDITY
To create a CD ladder, you invest your savings in CDs with varying maturities and interest rates. This approach may provide the opportunity to take advantage of higher rates on longer-term CDs while maintaining a portion of your funds in shorter-term CDs that will be more readily available, said Matthew King, a wealth planner for Wilmington Trust.
"The guarantee of a fixed rate of return on the principal invested over a set term and the ability to access the funds if necessary, are key benefits of using CD ladders," King said.
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It’s also important to mention that early withdrawal penalties could apply if you break the CD prior to its maturity date.
"Often, the penalty may entail a fixed fee to break the CD contract as well as a penalty based on a number of days of interest calculated at the current rate on the CD," King said. "These penalties can vary based on the term remaining until the stated maturity of the CD."
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Here’s how it works
By creating a CD ladder, you are investing your CDs to mature at different dates.
"This allows you to continually have CDs that are maturing versus all your funds being committed to an investment that will pay back the proceeds you have invested, plus interest you have earned, at one particular point in the future," King explained.
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But, the tradeoff in investing using CDs is that you do not have the opportunity to generate higher returns that may be available from other investments such as bonds or equities, and the rates earned by CDs may not allow your investments to keep pace with rising inflation, King said.
Consider King's example of a CD ladder as you think about your own need for liquidity and how long you are willing to commit the funds for. If, for example, you have $100,000 to invest and you want a CD ladder with an average maturity of 18 months, here’s how it could be constructed:
$20,000 in a 6-month CD earning .55% APY
$20,000 in a 1-year CD earning 1.00% APY
$20,000 in an 18-month CD earning 1.05% APY
$20,000 in a 2-year CD earning 1.15% APY
$20,000 in a 30-month CD earning 1.25% APY
The "APY," or annual percentage yield, is the rate of return on an interest-bearing account for a one-year period based on the interest rate and frequency of compounding.
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As you are planning your CD ladder, Williams advises matching the CD’s maturity with when you need the money.
"You’ll earn a bit of extra yield, in the meantime, compared to a checking account, and will have money for an emergency or anticipated expenses within your portfolio, as an investment, or for spending when you need it," he said.