I've seen the term "CD Laddering". What is this and what are the benefits and risks of doing it?
CD Laddering is a process of buying multiple CDs at longer terms to take advantage of better interest rates while still having liquidity.
The benefit of a CD ladder is based on this assumption. Without higher rates for longer terms, I wouldn't ladder CDs.
So, let's assume you have $10,000 to invest. And let's say you have a 12 month CD at 1% and a 24 month CD at 2% available to purchase.
You could lock all of your money up for 2 years and buy the 24 month CD at 2%. This is a good rate of return, but locks up your money for longer than you might otherwise have planned.
The laddering approach is to buy longer term CDs over a regular interval. In this case, we could buy a 2 year CD at 2% every 6 months. Your ladder would look like this:
- Jan 2011 - buy $2500 2 year CD at 2%
- Jul 2011 - buy $2500 2 year CD at 2%
- Jan 2012 - buy $2500 2 year CD at 2%
- Jul 2012 - buy $2500 2 year CD at 2%
This gives you the 2 year rate (2%) but you are always less than 6 months until your next CD matures giving you some liquidity.
When each CD matures, you then purchase another 2 year CD at the more beneficial rate. You'll always have something maturing every 6 months.
Now, if you want to start with your money immediately, you can seed your ladder by buying partial terms like this:
- Jan 2011
- buy $2500 2 year CD at 2%
- buy $2500 18 month CD at best rate
- buy $2500 12 month CD at best rate
- buy $2500 6 month CD at best rate
- Jul 2011 - buy $2500 2 year CD at 2% with funds from 6 month CD
- Jan 2012 - buy $2500 2 year CD at 2% with funds from 12 month CD
- Jul 2012 - buy $2500 2 year CD at 2% with funds from 18 month CD
The two year time maturity time frame and the interest rates are all examples. You could have 12 CDs with one maturing every month, one maturing every quarter, etc.
The benefits of CD Laddering are that a portion of your money is never far from maturity and that your interest rate is better than it otherwise would be.
The risks of CD Laddering are the same as the risks of buying CDs. If you think CDs are a good investment, CD Laddering is a good way to invest at higher rates.
This answer is to supplement the answers about what CD laddering is and what its benefits are. I'm going to talk about its risks.
CD ladders are subject to risk. They are not subject to very much credit risk and investment risk (they're federally insured! Barring the dissolution of the United States government as we know it, you will get all your money back!). However, they are subject to inflation risk and a little bit of interest rate risk.
A CD is basically a promise for a certain amount of money after a certain amount of time. Inflation risk happens when there's inflation and the money that you've been promised isn't worth as much anymore, because everything's gotten more expensive.
Interest rate risk happens when you buy a CD in a very low interest rate environment (like, oh, the year 2010) and rates subsequently rise. You might have been somewhat better off waiting for rates to rise before buying the CD. (Also, if you were to try and re-sell it, you would get an inferior price - enough to make up for the interest rate difference.) Note that interest rates tend to rise if there is a significant amount of inflation, so these two risks go together.
Interest rate risk and inflation risk are higher for longer-term CDs (at least right now) because there's more opportunity for inflation and interest rates to rise. 2010 has been marked by the extraordinarily low interest rate environment which prevails, and the Federal Reserve has announced that it is trying to bring about a higher rate of inflation (you may have heard something about a "second round of quantitative easing").
A quick look at interest rates show that 2-5 year CDs yield about 1.50% these days. You could, alternatively, get a savings account that yields 1.4%, preserves your liquidity, and will raise the rate it pays you on savings in the event that inflation and interest rates rise (or, if they don't raise it, you can move the account, unlike a CD).
In summary, as of right now (October 2010), fixed-income investments like CDs don't pay you very much and have elevated levels of risk, especially for long-term investment. This is one of the worst times possible to invest in a CD ladder.
You've asked for risks but neglected straight up costs. CD laddering will have some explicit and implicit costs:
- your time to set up multiple investments and manage them more frequently
- you lose some interest up front unless the yield curve is flat or inverted. If you have a lump sum and a long investment horizon, you're better off buying the max maturity length now and waiting to switch over to a ladder at the last minute, if ever.
- your bank's time to do all the paperwork for these deposits and handling you on a yearly (or monthly!) basis. This will show up somewhere, quite possibly your rates!
- by splitting up your principal, you may not qualify for jumbo CDs, which carry a slightly higher average yield, but also go beyond FDIC insurable deposit amounts.
CD laddering is funding a few CDs in succession. For instance: for 6 months, each month you open up a 6 month CD (rather than opening up one big one). Doing this will give you monthly interest payments as each month a CD will reach maturity (after 6 months). At that time you can choose to roll over the principal in a new CD and keep the interest, reinvest all, etc etc etc. You still get the benefits (higher rates) that CDs offer, but with greater flexibility and more frequent interest payouts. The only downside that I'm aware off is that you may end up with a slightly lower overall interest rate.
A CD ladder is an ideal way to hold your emergency funds and eke out a few more percentage points of return. Buy CDs in denominations close to one month's expenses, and ladder 1 per month with 3, 6 or 12 month CDs (depending on your total cash allocation to emergency funds).
By using a frequency that matches your available funds, in a best case scenario, you can perpetually roll over (or as your savings increase, extend to a longer frequency). If you have an emergency, you have a month's expenses in cash or cash coming in within a month.