A CD ladder is a strategy used by investors to create a predictable stream of income from certificates of deposit (CDs). CDs are a type of low-risk, fixed-income investment that pay a predetermined interest rate for a set period of time. CD ladders allow investors to take advantage of the benefits of CDs, such as guaranteed returns and the opportunity for higher interest rates, while also providing liquidity and flexibility.
What is a CD ladder?
A CD ladder is a way to invest in CDs with different maturity dates in order to create a stream of income. For example, an investor might invest in CDs with maturities of 1 year, 2 years, and 3 years. This allows the investor to receive a regular income from the CDs as they mature, while also having the flexibility to reinvest the money in new CDs as needed.
How to build a CD ladder
To build a CD ladder, an investor will need to decide on the following factors:
- The amount of money to invest: This will depend on the investor’s financial goals and risk tolerance.
- The number of CDs to invest in: A CD ladder typically consists of at least three CDs with different maturity dates.
- The maturity dates of the CDs: The investor will need to decide how frequently they want to receive income from the CDs. For example, they might choose to invest in CDs with maturities of 1 year, 2 years, and 3 years in order to receive income every year.
Using these factors, the investor could build a CD ladder as follows:
- CD 1: $3,333 invested at a 1-year term and 2.5% interest rate
- CD 2: $3,333 invested at a 2-year term and 2.7% interest rate
- CD 3: $3,334 invested at a 3-year term and 3.0% interest rate
Once these factors have been decided, the investor can then purchase the CDs from a bank or credit union. It is important to shop around and compare rates from different financial institutions in order to get the best return on investment.
Benefits of a CD Ladder
There are several benefits to using a CD ladder as an investment strategy:
- Predictable income: CD ladders provide a predictable stream of income as the CDs mature. This can be particularly useful for investors who are looking for a steady source of income.
- Higher interest rates: CDs generally offer higher interest rates than traditional savings accounts, and the longer the term of the CD, the higher the interest rate is likely to be. By investing in CDs with different maturity dates, an investor can take advantage of higher interest rates while also maintaining liquidity.
- Flexibility: CD ladders allow investors to reinvest their money as needed, allowing them to take advantage of changing interest rates.
- Low risk: CDs are a low-risk investment, as they are backed by the FDIC (Federal Deposit Insurance Corporation) up to $250,000 per depositor.
Drawbacks of a CD ladder
While CD ladders can be a useful investment strategy for some investors, they do have some drawbacks that should be considered:
- Low returns: CDs generally offer lower returns than other types of investments, such as stocks or real estate. This means that investors who are looking for higher returns may want to consider alternative investments.
- Lack of liquidity: CDs typically have a fixed term, which means that the investor cannot access their money until the CD matures. This lack of liquidity can be a problem for investors who need access to their money in the short term.
- Opportunity cost: By investing in CDs, investors may be missing out on opportunities to invest in higher-yielding assets such as stocks or real estate. Or if interest rates rise while an investor has their money invested in CDs, they may be unable to take advantage of higher returns.
- Taxes: The returns on CDs are taxed as ordinary income, which may not be the most tax-efficient way to invest for some investors.
It is important for investors to carefully consider the drawbacks of a CD ladder before deciding whether it is the right investment strategy for them. They should also consult with a financial advisor to determine the best course of action based on their individual financial situation and goals.
Alternative CD ladder structures
There are several alternative structures for CD ladders, including:
Rolling CD ladder: With a rolling CD ladder, the investor continually invests in new CDs as the old ones mature. This allows the investor to take advantage of changing interest rates and maintain a steady stream of income.
Ladder within a ladder: This structure involves building two or more CD ladders with different maturity dates. For example, an investor might build one ladder with CDs that mature in 1, 2, and 3 years, and another ladder with CDs that mature in 4, 5, and 6 years. This allows the investor to diversify their investments and receive income at different intervals.
Inverted CD ladder: An inverted CD ladder is a variation of the traditional CD ladder investment strategy. In an inverted CD ladder, the investor starts by investing in CDs with longer maturity dates, and then gradually invests in CDs with shorter maturity dates as they become available.
For example, an investor might start by investing in a 5-year CD, followed by a 4-year CD, and then a 3-year CD. This allows the investor to take advantage of the higher interest rates that are typically offered on longer-term CDs, while also maintaining some liquidity as the CDs with shorter maturity dates become available.
Are CD ladders a good investment?
CD ladders can be a good investment for investors who are looking for a low-risk, fixed-income investment with the potential for higher returns. They are particularly useful for investors who are seeking a predictable stream of income. However, it is important to consider the current interest rate environment and the investor’s financial goals when deciding whether a CD ladder is the right investment strategy.
CDs may not be the best choice for investors who are looking for higher returns or who are willing to take on more risk. In these cases, alternative investments such as stocks, REITs, high-yield bonds or mutual funds may be more suitable.
It is also important to note that the returns on CDs are taxed as ordinary income, so investors should consider the potential tax implications of a CD ladder in their overall financial plan.