January 2006

What is a CD ladder? How can I use one?

The CD “ladder” refers to a technique of investing in CD’s (Certificates of Deposit) where you break down a fixed amount of money and invest it in smaller increments over a certain period of time. It takes the guesswork out of where interest rates are going.

In a CD ladder, the available funds are divided equally between the term selected and invested into as many equal periods as the investor chooses. These time frames are often 1 year or 6 month increments. The 1-year increment ladder is most common. As CD’s mature, they are rolled into the longest term of the ladder to keep the structure in place. IE: a 5-year ladder with maturities every year. Would have 1/5 of the total invested funds maturing yearly.

As CD’s mature the ladder is maintained by investing into a new CD at the longest rung of the ladder.

An example of a short-term ladder could be a 2-year ladder with maturity every 6 months. A long-term ladder might have a 5-year term with a CD for an equal amount every year.

As an example, assume that you have $5,000 to invest and prefer the generally higher yields that come with long term CDs. You would purchase five CDs of $1,000 each:

CD # 1 for $1,000 for a one-year term,

CD # 2 for $1,000 for a two-year term,

CD # 3 for $1,000 for a three-year term,

CD # 4 for $1,000 for a four-year term; and

CD # 5 for $1,000 for a five-year term.

As the 1-year CD matures, roll it over into a new 5-year CD at the then existing rate and do the same thing as each subsequent CD matures. At the end of each year you will have one of the 5-year CD maturing.

With this strategy, you will have access to cash every year, enjoy the higher yields of a 5-year investment and diversify you risk. You don’t have to guess any more which way rates are going.