Early in May 2023, the Federal Reserve hiked interest rates for the 10th time, bringing the federal funds rate to a range of 5.00% to 5.25%. While this has hurt people who hold a balance on their credit cards, it’s turned back the clock and made certificates of deposit (CDs) attractive again. Yet no one knows where rates will go now. Some say there may be a temporary pause, others say we could even see rates decline as we near the end of the year. In this scenario, how do you invest in CDs to make sure you get the most return while still being able to access your money?
CD ladder
A CD ladder is a strategy for dividing your money among CDs that mature at different times. Maturities for CDs can range from three or six months to as long as one to five years. If you had $20,000 to invest for one year and you purchased a $20,000 CD to mature at the end of that year, all your money would be tied up for the full year (unless you were willing to pay a penalty for an early withdrawal). With a CD ladder, you can have different maturity dates so portions of your money are available at different times throughout the year.
How it works
Let’s assume you have $50,000 that you want to invest for five years while maintaining the ability to access 20% of it every year in case you have an unforeseen emergency. You would buy five CDs, each with a differing maturity; so in this example, you would put $10,000 in a one-year CD, $10,000 in a two-year CD, $10,000 in a three-year, $10,000 in a four-year, and $10,000 in a five-year CD. This means that at the end of the year your one-year CD would mature and you would be able to access the $10,000 plus earnings with no penalty.
At the end of the first year, your two-year CD has one year remaining until maturity (and the others also have one less year to maturity). So, in effect, it’s now your one-year CD and at the end of the coming year you will be able to access another $10,000 plus earnings.
After the first year if you don’t need to access your money and earnings, you may decide to reinvest the $10,000 (plus earnings if you choose) into a five-year CD and keep revolving the purchases over the coming years.
Reasons to ladder your CDs
Access to your cash. A CD ladder allows you to access your cash more often than if you invest a lump sum into a longer-maturing CD. With the ladder above, you can choose to pull $10,000 per year or reinvest it.
Advantage of long-term CD interest rates. Normally, interest rates on longer-term CDs are higher than those on short-term CDs. This makes sense – you should make more for locking up your money for five years instead of just one year. With a ladder, you can portion part of your money to earn these higher rates.
Competitive options. You can’t read a newspaper without seeing a bank ad detailing their CD offerings. And sites like Nerdwallet and Bankrate both offer lists of highest yielding CDs. When your CD matures you can easily compare rates and choose the best option for your needs.
FDIC insured. Money market funds recently have performed in lock-step with CDs, and sometimes even outperformed them. However, while considered safe, money market funds aren’t insured. CDs purchased at one financial institution are insured up to $250,000 should the bank fail.
Reasons to rethink laddering
Losing to inflation. CD returns have only recently equaled the rate of inflation, with both coming in around 5%. When inflation ranged from 6% – 9%, money invested in CDs lost value. Since short-term CDs tend to offer lower rates, the discrepancy could be even greater on the money that will mature soon.
Taxes. Earnings from your CDs are taxed at ordinary income levels, unlike stocks which receive capital gains treatment. If you are in a high tax bracket, you may look at the after-tax return and choose more tax-advantaged bonds, like I Bonds or municipals.
Homework for the investor. Unlike many investment options, this isn’t a set-it-and-forget-it option. You will need to review your cash needs at the end of each maturity period, then determine if your current bank offers the best options for reinvestment.
Ladders may not outperform one big investment. Recently one-year CDs have paid more than a three-year CD; in other times, a five-year CD has outperformed. Depending on market movements, your ladder could outperform or underperform other CDs that were available when you chose the ladder. The key is a ladder provides a ready source of cash while a longer-term CD would lock up that cash.
Who should do it
For people who have a portion of their portfolio in cash or cash equivalents, a CD ladder can be beneficial. Perhaps you’re about to pay for your kid’s college expenses or are using a three-bucket retirement income system and need short-term cash readily available.
But know that investing in CDs isn’t recommended for long-term money. While CDs are returning rates not seen in years, 5% still falls well short of the long-term return from stocks. Financial experts agree that you should invest for the long-term in stocks.
Clearly evaluate when you will want to access your money so that you can build a ladder to mature when you need it. You don’t want to be forced to pay penalties for early withdrawals.
Photo by Pille Kirsi