Certificates of deposit provide savers with the ability to lock in the current interest rate, though the Federal Reserve has indicated rates will remain low for several years.
If you decide to put your money into CDs, you have the option of using a CD ladder, which ensures that each CD matures at a different time interval. One feature of the CD ladder strategy is getting access to your cash sooner, without penalty. This can be even more critical since the coronavirus pandemic has made job security weak in several sectors.
Savers may choose CDs because they provide a guaranteed interest rate over a set period of time, from as little as a month to seven years or more. People also use CDs to receive a slightly higher interest rate compared with what a regular checking or savings account pays, says Daren Blonski, managing principal of Sonoma Wealth Advisors in California.
CDs are a safe investment because they are insured by the Federal Deposit Insurance Corp. for up to $250,000 per individual, and unlike investments in something like stocks, CDs don’t put you at risk of losing your principal. However, if you withdraw your funds before the CD matures, your bank will impose a penalty, such as losing some of the interest your account had earned.
“The advantage of a certificate of deposit is the certainty that you will get a certain amount of money at a specific point in time,” says Greg McBride, senior vice president, chief financial analyst at Bankrate, a financial data company. “The federal deposit insurance protection makes this a risk-free return, which is a draw for savers seeking safety.”
How to Build a CD Ladder
Savers who want to use a CD ladder will allocate their money into several CDs that mature at different times with varying interest rates. Laddering CDs is a strategy that can help savers take advantage of higher interest rates, especially people who are retired and seeking a steady income.
Let’s say you have $30,000 to invest in CDs. You could put the entire amount into a single CD that matures in two years. But if interest rates increase before that CD term ends, you’re stuck with the lower rate. And if you need access to some of that money before the two years are up, you will be hit with a penalty from your bank.
With a CD ladder, however, you could do this:
- $10,000 in a one-year CD.
- $10,000 in a two-year CD.
- $10,000 in a three-year CD.
After one year, you can place the $10,000 from the one-year CD – plus any interest you earned – into a new three-year CD. In another year, your original two-year CD will mature, and you can take those funds and place them into another three-year CD. Then, in still another year, your original three-year CD will mature, and you can put the money in a new three-year CD.
In the above example, you can continue in this fashion by opening new three-year CDs every year. Because you’re using a CD ladder, one account matures every year, so you have the yearly option to withdraw some or all of each CD’s funds and not lose any of the money you’ve earned.
“Laddering your CDs means you will always have some money coming due and you are maximizing as much interest as you can on that amount of money,” McBride says.
This is a strategy consumers use to diversify their money among a range of maturity dates and so that “not all the money gets invested at a low point in interest rates,” he says.
“Laddering is an all-weather strategy,” McBride says. “With a prolonged environment of low rates likely, laddering may not produce the same benefits that it would if rates were more volatile, but can still be a useful strategy.”
Savers who believe the Federal Reserve will keep interest rates low for the next couple of years should avoid putting money into CDs that mature in three or five years and stick with ones that mature in one year or less, Blonski says.
“Right now, it’s a gambler’s dilemma,” he says. “You have to have an opinion about interest rates when you put money into CDs. Otherwise, making a decision is a pretty challenging process.”
Interest rates for savings accounts and CDs have continued to dip this year as the Federal Reserve has stated its intent to keep the federal funds rates near zero. While a low-interest-rate environment is beneficial to people with mortgages and other debt, savers, especially retirees, are facing extremely low yields – such as 0.65% or lower for 12-month CDs at Ally Bank. Even a three-year CD only yields 0.75%.
Meanwhile, the widespread impact of the pandemic has led to job losses, furloughs and cuts in working hours, resulting in some people cashing out of their CDs before they mature.
“Because of the difficult economic climate, savers may find they need to cash a CD early,” McBride says. “Check with your bank before doing so, as there may be flexibility to waive early withdrawal fees that didn’t exist pre-COVID. It doesn’t hurt to ask.”
Alternatives to CD Ladders
In addition to laddering CDs, savers can invest in other types of CDs. A liquid CD allows you to withdraw money without incurring a penalty.
“A liquid or no-penalty CD can be attractive because you have the ability to cash out early if interest rates rise,” McBride says. “Just make sure the return you’re getting in the meantime is competitive with the top-yielding CDs; there is no sense in forgoing too much interest for a benefit you aren’t certain to use.”
Another type of CD is called a bump-up or step-up CD, and it has the flexibility to increase the interest rate at some point during the term of the CD. Ally Bank has a version called the Raise Your Rate CD, since people can take advantage of an increased interest rate once during the two-year CD or twice during a four-year CD. This type of CD is more disadvantageous during a low-interest rate environment, and savers should stick with establishing a CD ladder instead, McBride says.