How to Maximize Your CD Rates with a Certificate of Deposit Ladder

Posted by on Aug 21st, 2009

If you have a lot of money in a savings account, you are at the whim of whatever the current interest rate environment is. If the economy falters as it has in the last  year, the rates you will be able to receive on your money will be dismal if you have it in a traditional savings account, a money market account, or have it in a certificate of deposit that is coming due.

Fortunately, there is a way to prevent yourself from having to renew all of your savings in a new certificate of deposit in a very low interest rate environment. This will help you average out the interest rates that you receive and prevent you from being a victim of the prevailing cd rates. The process is known as “laddering” your CD’s.

First, Let’s get back to basics. What’s a Certificate of Deposit? Essentially, it’s a guaranteed investment for your money. You invest a dollar amount on a given date and the bank promises you to give your money back plus a fixed amount of interest after a specific period of time, usually 6 months, 12 months, 18 months, 36, months or 60 months.  The bank takes your money, loans it to other customers and banks and hopefully makes more money off it and returns your principal and interest to you. If the bank runs into trouble, you will typically have the backing of the FDIC to make sure that you get your money.

Laddering a CD essentially makes it so that one fifth of your money in certificate of deposits comes up for renewal each year, so that means you will be able to withdraw one-fifth of your money without penalty. For the first year, you would put 1/5th of your money in 1, 2, 3, 4 and 5 year CD’s respectively. When the CD matures, you then renew it for another 5 years at the best interest rate you can find. Since one fifth of your money is up for renewal each year, the remaining 4/5ths of your money will keep earning the same interest rate, and only one fifth of your money will be up for renewal.

For example, let’s say you had $5000 to invest and the prevailing CD interest rate was 3%.

You would initially make the following investment:

  • $1000 in a 1 year CD at 3% (1 year remaining)
  • $1000 in a 2 year CD at 3% (2 years remaining)
  • $1000 in a 3 year CD at 3% (3 years remaining)
  • $1000 in a 4 year CD at 3% (4 years remaining)
  • $1000 in a 5 year CD at 3% (5 years remaining)

After the first year, let’s say CD rates went up to 5%, your portfolio would now look like this:

  • $1000 in a 5 year CD at 5% (5 Year Remaining)
  • $1000 in a 2 year CD at 3% (1 Year Remaining)
  • $1000 in a 3 year CD at 3% (2 Year Remaining)
  • $1000 in a 4 year CD at 3% (3 Year Remaining)
  • $1000 in a 5 year CD at 3% (4 Year Remaining)

After the second year, let’s say CD rates went up to 1%, your portfolio would now look like this:

  • $1000 in a 5 year CD at 5% (4 Year Remaining)
  • $1000 in a 5 year CD at 1% (5 Year Remaining)
  • $1000 in a 3 year CD at 3% (1 Year Remaining)
  • $1000 in a 4 year CD at 3% (2 Year Remaining)
  • $1000 in a 5 year CD at 3% (3 Year Remaining)

After the third year, let’s say CD rates went up to 4%, your portfolio would now look like this:

  • $1000 in a 5 year CD at 5% (3 Year Remaining)
  • $1000 in a 5 year CD at 1% (4 Year Remaining)
  • $1000 in a 3 year CD at 4% (5 Year Remaining)
  • $1000 in a 4 year CD at 3% (1 Year Remaining)
  • $1000 in a 5 year CD at 3% (2 Year Remaining)

After the fourth year, let’s say CD rates went down to 3%, your portfolio would now look like this:

  • $1000 in a 5 year CD at 5% (2 Year Remaining)
  • $1000 in a 5 year CD at 1% (3 Year Remaining)
  • $1000 in a 3 year CD at 4% (4 Year Remaining)
  • $1000 in a 4 year CD at 3% (5 Year Remaining)
  • $1000 in a 5 year CD at 3% (1 Year Remaining)

If you had invested all of your $5000 in 1 year CD’s and renewed them each year, you would end up with about $5850 at the end of the fifth year. There would be a year where you only earned 1% of your money in there, but there would also be a year where you earned 5% on your money. (ouch!). At the end of the fifth year, you would have protected yourself from volatility in interest rates and earned an average of 3.2% back on your money.

Although you likely won’t make substantially more using a CD latter than a year-to-year certificate of deposit ,you will be able to minimize the damage that an extremely low interest rate environment can bring to your portfolio by averaging the rate of return that you get over 5 years.