How certificate of deposit (CD) laddering works

Picture a household ladder in your mind. Pretend there is a certificate of deposit (CD) on each step. Then assume you can remove one per day and cash it in. You are now a CD laddering expert! Well, maybe not quite an expert, but you should have a simple mental picture of how CD laddering works.

Banks, credit unions, and other financial companies use CD laddering on a daily basis for two primary reasons:

1. Provides a constant cash flow

Laddering CDs provides a constant flow of cash to meet expense obligations and provide funds for new investments.

2. Creates variance

CD laddering eliminates having too many investments "stuck" with an earnings rate that becomes below market when rates are trending upward.

Keeping your investment portfolio at current market rates (even if rates are trending downward) may prevent you from making an unexpected windfall profit, but, more importantly, this plan ensures that you shouldn't lose money because of prior decisions.

Tips on how the ladder CDs

Individuals can accomplish the same goals by laddering their CDs. Here's how to do it.

Decide on a total dollar amount

Decide how many total dollars you want to commit to a CD laddering program. The amount you have to invest is immaterial. Whether it's $5,000 or $500,000, the program works the same way. It is important to decide what your "pool" of funds will be.

Decide on a timing strategy

Decide on a "timing" strategy for prospective certificates and deposit maturities. For example, you might decide to purchase a one, two, three, and five year CD with your savings.

This means that, after the first year of your plan, you'll have one CD mature – and get access to some more of your money almost every year thereafter.

Decide on an allocation strategy

Decide how you would like to allocate your savings dollars. You might choose to simply divide your savings into four equal parts. Take your $5,000 and put $1,250 into each CD.

Should you want to be a bit more analytical, you might try to anticipate what future interest rates might do. If you believe short- or longer-term rates will move in one direction or another, you might want to allocate your investments to reflect this anticipated trend.

Strong advice: Be careful and conservative with this approach. Even the experts are often proven wrong on a regular basis with interest rate predictions.

Purchase your CDs

Purchase CDs in the variety of time frames you choose. Then sit back and relax. If your CDs are in federally insured U.S. banks or credit unions, your principal (CD purchase amount) is protected.

In the example, your ladder periods are one, two, three, and five years. This structure is relatively simple and straightforward. A plan set up like this should not take too much time or financial babysitting on your part.

There is little risk as you earn an interest rate guaranteed by your CD agreement. Unless you've selected a variable rate CD, which is sometimes available, your earnings rate will remain constant during the term of your savings agreement.

The advantages of CD laddering

The advantages CD and investment laddering that financial institutions have enjoyed for years are available to you. You have diversified the term of your investments so you will have a portion of your total investment returned to you on a regular basis.

This keeps more funds flowing into your hands with which you can make new investments. Because of the constantly changing markets, it is important that you have funds available to take advantage of earnings opportunities as they appear.

Another major advantage of laddering CDs is the level of interest rate protection. Typically, your interest rates will be lowest for the shortest term CDs in your portfolio and higher for the longer-term investments.

But you face the highest interest rate "risk" with the longer-term CDs because your start rate is the one you will have for the entire period. Obviously, the interest rate market can change, for better or worse, many more times during the term of a five-year CD than it can for a two-year CD.

By laddering your CDs you will have a relatively constant flow of money to allow you to take advantage of current interest rates, particularly beneficial if your funds are available during an upward trend.

Even if the trend line is down when you receive your CD proceeds, you have the ability to wait a while until the trend reverses. You can then immediately purchase another CD as rates rise.