This blog contains some simple tips and advice from two regular guys. We're not accountants, financial advisors, or brokers, so follow, ignore, or discuss our ideas as you see fit.

Thursday, August 23, 2007

Are CD Ladders Worth The Climb?

Posted By Paul

Another investment/savings device I've heard of is the CD ladder.

First a super quick overview of a CD:

The basic idea is that you go to some sort of bank and get a CD that has a specific term and interest rate. So let's say you get a $100 3 year CD at 5%, that means that your $100 will earn a guaranteed rate of 5% for the next 3 years. Super low risk, super not too exciting return, but there is a time and place for that type of investment.

So knowing this about CD's, what is the idea behind a CD ladder? Well the best way to understand the idea behind a CD ladder is to understand the two extreme cases that the CD ladder tries to avoid.

Let's assume you have $5000 and you'd like to put it somewhere really safe and earn a guaranteed rate of return.

Extreme Hypothetical Case 1:You buy a $5000 5 year CD which gives you an interest rate of 5%. Then in a month the interest rates jump up to 8%. Now you're annoyed because your money is locked up for 5 years at the now paltry rate of 5%.

Extreme Hypothetical Case 2:You buy a $5000 1 year CD which gives you an interest rate of 5%. Then in a month the interest rates plummet to 2%. Now you wish you had locked your money in at 5% for a longer amount of time.

So a CD ladder is just a way of covering both of these cases. Instead of buying a super short term or a super long term CD you instead create a ladder of CD's of varying terms. So now the scenario would be:

You buy a $1000 1 year CD.

You buy a $1000 2 year CD.

You buy a $1000 3 year CD.

You buy a $1000 4 year CD.

You buy a $1000 5 year CD.

You set each CD to roll into a 5 year CD when it matures. So after a year, the 1 year CD becomes a 5 yr, the 2 year has one year left, and so on.

So with this situation, let's say interest rates go up a lot. You get to say:

"Oh well, in one year I get to take advantage of that cool rate when my one year CD renews."

Also if the interest rates go down a lot you get you get say:

"Oh well, at least I have some of my money in that nice 5 year CD at the better rate."

It's nothing magical, just a way to hedge your bets, and not a bad thing to do if you have a chunk of money you want to put away for a rainy day.

One point to note is that ING (and I would imagine other banks) have the option of specifically setting up a CD ladder, where the interface asks you the total money you want to invest and the interval between them and it automatically sets up the ladder (not that it's hard to set up manually).

Also, some people don't like CD's because you have to lock your money up. The good news is that with all CD's that I've heard of you actually can cash the CD at any time, there is just a flat penalty for doing so (in my experience the penalty is often equivalent to the amount of interest you would make in 3 months). So if you set this up and then at some point in the future you have an emergency and need to access this money, you can cash out, eat the penalty and have your money back (plus any interest less the penalty) immediately.

1 comment:

Matt said...

One quick comment...CD ladders strike me as a type of "training wheels" for learning to save. You can get equivalent rates from Internet Savings Accounts these days (see Paul's previous post), which are simpler, but the CD's early withdrawal penalty may work as a disincentive to moving money in and out the way that someone might with a savings account. That being said, I would probably still recommend funding a CD ladder AFTER I had an emergency fund set aside in a savings account.