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- A certificate of deposit offers a fixed interest rate, but penalty-free withdrawals aren't allowed.
- With a CD ladder, you split your total deposit into multiple CDs with different maturity dates.
- A CD ladder provides more flexibility than a single CD and hedges against interest rate volatility.
In an effort to fight inflation, the Federal Reserve has raised rates several times throughout 2022 and in early 2023. When the federal funds rate increases, it affects the interest rates of banking products like savings accounts, money market accounts, and CDs.
CD rates in particular have gone up significantly over the last year. Since savers pledge to keep their money in a CD for a certain period of time, these accounts are often able to offer higher rates than typical savings accounts. For these reasons, some savings account holders may be seriously considering moving a portion of their funds to a certificate of deposit.
There are downsides to CDs, however, including reduced liquidity and the danger that interest rates could rise while you're locked in at a lower rate. But by setting up a CD ladder, savers can minimize many of these disadvantages.
What is a CD ladder?
If you're not familiar with a certificate of deposit, it's a type of deposit account that is offered by banks. Like other bank accounts, CDs are insured for up to $250,000 by the FDIC.
Unlike savings accounts, CDs offer fixed interest rates. But in exchange, CDs generally do not allow penalty-free withdrawals until the maturity date. CD maturity dates can range from as short as one month to as long as 10 years. In general, the longer the maturity date, the higher the rate that the bank or credit union is willing to offer.
A CD ladder is a plan in which you split your total deposit into multiple CDs that each have different maturity dates. Instead of putting $10,000 into one CD, for example, you could divide the money into $2,000 increments split between five CDs maturing at varying times from one to five years.
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What are the advantages of a CD ladder?
CD ladders offer several benefits. First, since the CD ladder will include some shorter-term CDs, it provides more liquidity than just buying a single long-term CD. Knowing that at least a portion of your overall savings pot will be available to withdraw penalty-free in a year (or less) can be reassuring.
On the other hand, there will also be longer-term CDs included in the CD ladder, which gives savers the opportunity to take advantage of high interest rate offers. Instead of having to choose between liquidity or higher rates, building a CD ladder gives you the opportunity to enjoy a little of both.
Finally, using a CD ladder can protect against interest rate volatility. If interest rates go up, you'll have the opportunity to buy new CDs at the higher rates each time one of your shorter-term CDs matures. Conversely, your longer-term CDs can protect against a decreasing interest rate environment since you'll be locked in at the older (and higher) rates.
What are the disadvantages of a CD ladder?
While CD ladders have many advantages, there are a few disadvantages to be mindful of. For instance, CD ladders require time and effort to maintain. You'll have to keep track of all your CD maturity dates in order to avoid early withdrawal penalties.
Another thing to keep in mind is that other options may offer significantly higher returns. If you are comfortable taking more risk with your money, you could invest in the stock market. Experts do not recommend investing money that you'll need in the next five years, though.
How do you build a CD ladder?
To build a CD ladder, begin by choosing a bank or credit union that's currently offering some of the top rates.
Next, you'll open the various CD accounts that will form your ladder. Here's an example of how you could split a $10,000 deposit into five different CDs:
- 1-year CD: $2,000
- 2-year CD: $2,000
- 3-year CD: $2,000
- 4-year CD: $2,000
- 5-year CD: $2,000
As each CD nears its maturity date, you'll have two options. First, you can simply allow it to mature so that the funds can be withdrawn penalty-free. Or you could renew into a 5-year CD. Here's how the renewal schedule would work if you built your initial CD ladder in April 2023:
- April 2024: Renew the 1-year CD into a 5-year CD
- April 2025: Renew the 2-year CD into a 5-year CD
- April 2026: Renew the 3-year CD into a 5-year CD
- April 2027: Renew the 4-year CD into a 5-year CD
- April 2028: Renew the 5-year CD into a new 5-year CD
By continuing to renew maturing CDs into 5-year variants, eventually your entire ladder will consist of longer-term (and hopefully higher-paying) CDs. Yet you'd still continue to have one CD reaching maturity per year.
Which maturity dates work best for a CD ladder?
The example shown above is just one of many ways to build a CD ladder. You can also choose to build a CD ladder with different amounts. For example, you might deposit only $1,000 in a 1-year CD, and deposit an extra $1,000 in your 5-year CD. This is called an uneven split ladder.
You could also set up a mini CD ladder with shorter-term CDs. For example, you could split up $7,500 into three CDs that will mature within a year, as shown below:
- 3-month CD: $2,500
- 6-month CD: $2,500
- 12-month CD: $2,500
Or you could split up $20,000 into four CDs that will each mature within two years:
- 6-month CD: $5,000
- 12-month CD: $5,000
- 18-month CD: $5,000
- 24-month CD: $5,000
Typically, longer terms also mean higher rates. However, what's most important is when you'll actually need to access the cash. For instance, if you think you'll need the full amount of cash accessible within three years, then you won't want to include any 4-year or 5-year CDs in your ladder.
Which types of savings goals are a good fit for a CD ladder?
While setting up a CD ladder provides more flexibility than a single long-term CD, it's still less liquid than a savings account. You're still likely to incur one or more early withdrawal penalties if you need to withdraw all of your money at once.
For this reason, building a CD ladder for your emergency fund could be a risky idea. Liquidity is the most important factor when it comes to picking an account for your emergency savings, so a high-yield savings account is still likely your best option.
A CD ladder is also not a true alternative to the stock market for long-term investing goals. The benefit of a CD ladder is that the interest rate is guaranteed. But if you know you won't need to touch the money for at least five years, you're likely to earn a higher return with stocks, bonds, index funds, ETFs, or other non-guaranteed investments.
You may want to consider a CD ladder, however, for the money you've set aside to buy a home three years down the road. Or you might want to build a CD ladder for money that's been earmarked for a car purchase in two years. A CD ladder can be a great fit for mid-term savings goals like these that have a specific purpose.