CD Ladders

“There's a way of transferring funds that is even faster than electronic banking. It's called marriage.” – anon

During normal economic times (of which this isn’t) you earn more money on a CD with a longer maturity period. For example a 1-year CD should give you a higher interest rate than a 6-month CD. Even better rates can be found a 2-year, 5-year or 10-year CD. However the problem with long term CDs is that your money is locked up. Yes you can cash in early but you pay a “substantial penalty for early withdrawal.”

The ability to access your money when you want and need it is called cash flow and liquidity. Long term CDs are a great investment but bad for your liquidity. Fortunately there is a trick called CD Ladders for getting better rates while preserving some cash flow. It works like this:
Suppose you have $10,000 to invest. You put $2500 into four CDs with different maturity dates: 3-month, 6-month, 9-month, and 1-year. But wait, there is more. At the end of 3 months, reinvest that money in a 1-year CD. Likewise as each CD matures, put the money back in as a 1-year CD. What you will have after 9 months is 4 CDs, each with a 1-year maturity but scattered in time. You will never more than 3 months away from a CD maturing.

BOTTOM LINE

Does this work? Yes if you stick to 1-year CDs or some other fixed rollover period.
In my case, my wife created a nicely spaced ladder but when each CD expires, she renews at the best current short-term rate. This is sometimes 6-months or 9-months or a year. We lose the nice rung spacing in the ladder and somehow our four separate CDs always seem to converge and mature very close to one another. We could stick the to 1-year plan but instead we value the best rate over the best CD liquidity. For cash flow we keep an emergency fund in a savings account that could pay our bills for 3 months. The rate is lousy but the cash is always there should be need it. It would take a huge emergency for us to spend through the entire nest egg and become reliant upon the cash locked up in the CDs.

Also keep in mind that any plan you follow must be adjusted for life changes. If you have a big wedding or other known expense coming up, you might switch all your CDs to mature just before the big event so you’ll have the cash you need. When I was laid off last year and our CDs matured, we renewed them at 3 or 6 months so that they would be within reach if needed. Now that I’m employed again, we will extend out the maturity periods one more.