Posted by Cindy Wilson.
CDs are risk-free—and the longer your money is locked up, the better the potential returns.
When you glance at your bank account balance, do you ever get the sinking feeling that thereʼs too much money sitting there? Not the worst situation to be in, granted, but you may be better off spreading that surplus cash across a “CD ladder.”
Whatʼs wrong with having a fat checking or savings account balance?
In exchange for liquidity, regular checking or savings accounts typically offer low interest rates. One way to get a better return on your cash is by locking it into a Certificate of Deposit (or CD) for a given timeframe: A two-year CD is not uncommon. Generally with CDs, the longer the term, the higher the interest rate. Therefore, CDs can be useful for sums of money that you donʼt require immediate access to but also donʼt necessarily want to tie up in a higher-risk, long-term investment, such as a bond. And since most banks offer them, transferring cash from a regular bank account into a CD, should be seamless. That being said, shop around to see which financial institutions are offering the best CD rates.
Thereʼs also the temptation factor: When money is too liquid, itʼs too easy to spend. So CDs can be an effective way of preventing you from spending your money on stuff you donʼt really need, especially if youʼre an impulse buyer.
A guaranteed rate of interest
The interest rate on a CD is generally fixed for the specified duration, be it two or six years. The security of knowing exactly how much youʼll get back when your CD matures provides peace of mind. However, keep in mind that locking your cash in a fixed-interest rate can have some downsides. For example, suppose that interest rates rise in the next two years, and youʼve locked some of your cash in a six-year CD that you could have used in a higher-earning vehicle.
What if you need access to your money before the CD matures?
When the CD matures, youʼll get your money back along with the accrued interest. However, itʼs important to know that if you choose to withdraw the money before the maturity date, youʼll have to pay a penalty. For that reason, you should have a liquid emergency fund set up for medical catastrophes and other unforeseeable events; hardship withdrawals from a CD should be a last resort.
Hereʼs a strategy that brings some flexibility to the benefits of CDs … Build a “CD ladder”
If you donʼt want to tie up all your spare cash for a long period of time, you can choose a more staggered approach, siphoning some into a two-year, some into a four-year and some into a six-year CD, each one with its own interest rate. This all depends on your short- and long-term goals, and when you think youʼll need access to the cash. The goal is to take advantage of longer maturities and higher interest rates, while making some of your money available, at regular intervals.
Letʼs say you divide your investments into one-, two-, three- and five-year CDs, starting with a $5,000 total from which you put $1,000 into each. When the first one matures after just a year, you have access to some cash if you need it. Whatever you donʼt readily need, you can reinvest in a five-year CD, getting the best deal you can find in terms of interest rates. The following year, your two-year CD will mature and you can do the exact same thing (another five-year CD) so the laddering will continue indefinitely.
If you donʼt want to wait a year for each CD to mature, you can be flexible and divide your investment into a CD that matures at monthly, three- or six-month intervals. In the event that interest rates rise in the interim, you can then use the available cash to take advantage of better deals.
When building your CD ladder, you need to consider:
- The current interest rate. If you expect it to go down, lock as much as you can in a longer-term CD. If youʼre living in a low interest rate environment, like now, you may anticipate a rise and therefore, consider shorter-term CDs.
- Look at your short- as well as medium- and long-term goals: Do you plan to buy a car in a couple of years? Do you foresee needing a huge wad of cash for that wedding next year? Think carefully about when you need access to your cash, and select CD timeframes accordingly.
To sum up, the benefits of CDs are clear. Because the rate of return is guaranteed, they are a very conservative, secure way to invest. And when compared to the money in a checking or savings account, with their negligible interest rates, CDs are more likely to outpace inflation.
In addition, laddering can provide some much-needed flexibility.