The current era of historically low interest rates has been great for borrowers, but it stinks for those who’d rather save their money. I was fortunate to find a local bank that offered a money market account at 2.25% last year, but after a couple extensions, I received notice that “bonus rate” was expiring at the end of this month. The old rate was in the 1.0% APY range.
I could simply stash my emergency savings with Smarty Pig - currently earning a 2.15% APY – but I prefer to keep a portion of the savings local. So, I’m off to find a way to boost my returns on local savings products.
So now I’m left to find a new home for some of our savings. Keep in mind this money is targeted for emergencies and short term (less than a year or two) goals. With everything else we are investing in dividend stocks and conservative life-cycle mutual funds inside Roth IRAs and my 401k.
Rather than leaving our money to languish at 1% interest, I would like to find a way to triple the earnings, without too much effort (after all, this isn’t “investing” money). Over the last couple weeks I’ve been investigating CDs.
I have to first confess, I’ve never owned a CD – mostly because up to this point I have never had enough money to invest in something that is locked up with a penalty for cashing out. Thankfully, that is beginning to change after our family recently reached debt freedom.
CDs may offer a slightly higher yield than I receive now from my local bank (and most online banks), however the requirement to tie up money for a number of years is not attractive to me. That was until I discovered the concept of CD laddering.
How to Ladder CDs
The real beauty of creating a CD ladder is that you don’t have to obligate your entire amount of savings into a 12-month CD to get a positive result. Instead, I recommend starting in the smallest increments you can tolerate and build from there.
Here’s an example using average rates collected from a number of CD offerings at Ally Bank, ING Direct, MonitorBankRates.com, and my local credit union. (I decided an average for each term would be easier than pinpointing a specific rate that could change before this article is even published). September rates are a wishful guess at what rates might look like by Fall, and were only changed to give you an idea why laddering could be a smart move given the idea rates will rise in the near future.
July Purchases ($2,000):
- $500 3-Month CD matures in October 2010 (0.75%)
- $500 6-month CD matures in January 2011 (1.15%)
- $500 9-month CD matures in April 2011 (1.15%)
- $500 12-month CD matures in July 2011 (1.50%)
August Purchases ($2,000)
- $500 3-Month CD matures in November 2010 (0.75%)
- $500 6-month CD matures in February 2011 (1.15%)
- $500 9-month CD matures in May 2011 (1.15%)
- $500 12-month CD matures in August 2011 (1.50%)
September Purchases ($2,000)
- $500 3-Month CD matures in December 2010 (0.90%)
- $500 6-month CD matures in March 2011 (1.25%)
- $500 9-month CD matures in June 2011 (1.50%)
- $500 12-month CD matures in September 2011 (1.65%)
*Note, I am using a 3-6-9-12 month maturity schedule to build a 12-month CD ladder. You could use a 6-12-18 month maturity schedule (or greater) to build an 18-month (or longer) ladder. A longer term ladder will earn higher rates, but will take longer to get going and will tie up your money for a longer period up front. It’s up to you to determine how much of your savings you can tie up, and for how long.
Beginning in October 2010, when our first 3-month CD purchase matures, I will use that original $500 (plus accumulated interest) to purchase a 12-month CD at a higher interest rate. In November, when the second 3-month CD expires, I’ll roll it into a 12-month CD purchase, and so on. In one year, I’ll have a rolling 12-month CD ladder of twelve one-year CDs.
One advantage of using these shorter terms is that when rates are rising, which I suspect they will be doing slowly over the next year or two, you can quickly take advantage of these new, higher rates without having to wait for a 6-month CD at a lower rate to expire.
Why Not Purchase 3-5 Year CDs At Higher Interest Rates?
If you lock into a CD for three or five years, you will miss out on interest rate increases. And this would be bad assuming they increase at a pace faster than the premium received for locking your money in longer.
It’s a bit of a guessing game – kind of like investing in the stock market. However, because these CDs represent a portion of my emergency fund (just a portion – not the entire thing), and funds for short-term goals, I’d rather have a little money coming back to me month-to-month, just in case.
Some lenders offer “penalty-free” CDs, which offer a lower interest rate for the option of cashing out without penalty before the CD matures. Personally, I’d probably go with the higher rate if my finances were sound with the understanding in a real emergency, I’d sacrifice a month’s interest as a penalty for accessing the money early.
Other lenders are offering what’s known as a “step up” CD. The Ally Bank Raise Your Rate CD is one such a product, which offers the ability to step up to a higher interest rate once during the term of the CD. It’s an interesting idea, but the minimum terms are typically longer than my liking.
CDs laddering seems to be something worth trying, and could be more profitable when interest rates rise again. I will go ahead and get the CD ladder in place now so that I will be ready to take advantage of higher interest rates in the future. If nothing else, I’ll earn a few more dollars on my savings for my troubles.
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Yeah, now is not the time to be locking into interest rates, as they will (almost) certainly be rising over the next few years. (Unless of course, the economy plunges into a depression.)
I hear from some experts that interest rates will stay low for years to come. I just can’t believe that. At some point you have to believe rates will tick up as inflation begins to creep back in and the economy stabilizes (we still have work to do here, I’m afraid).
Usually the larger the amount, the better the interest “break”…
If the interest from $500 – $2000 is the same rate, and the time frames produce the same interest, then this method works well as described.
If, however, there is an interest break at $1000 or $2000, then one would want to consider making the ladder that way…. Each person’s ladder will be determined by what breaks and perks their own bank offers, based on amounts and time frames.
I totally agree on NOTHING real long term right now – 13 months is my longest one right now – as there was an interest difference between 12 months and 13 months that made it worthwhile – hopefully.
Another option is to have a smaller one month or two month CD – that just keeps turning over every month or two months….and then put the rest of the ladder into longer term CD’s with a better interest rate.
Depends on each person’s comfort level… I usually felt like 2 months was the minimum roll over that I needed – most anything could wait for up to two months – even if I had to put something temporarily on the credit card til the CD matured for an emergency situation.
CD laddering is a good game to be playing – but make it work best for your own situation – as you can use whatever CD rules fit you best
Excellent points regarding the interest rate break on larger CDs. I hope, over time, to consolidate/add to a few of these 12-month CDs and lock in a higher interest rate with a larger deposit. My credit union offers higher rates on “jumbo certificates,” but I’ve got some saving to do to reach “jumbo” status!
Why don’t you just put your money in Smarty Pig for the short term – over 2% interest – more than any of the CD’s you are thinking of investing in. You can just split the money up into individual goals called 3 mo, 6 mo, 9 mo etc and then just cancel one or more goal if you really need the money or the rates go up. Makes no sense to keep the money tied up and incur penalties when the difference in interest is so negligble.
I actually do have a Smarty Pig account, with a small bit of savings there for a targeted savings goal. My hope is that my ladder will eventually grow to include longer-term and/or larger CDs with higher interest rates (as Marci alludes to above).
I guess I am more pessimistic than you as I don’t think interest rates are moving much higher anytime soon. And if they do, the bank interest rates will always increase slower than say mortgage rates. I have thought about putting my E-Fund in CD ladders but can’t justify putting the money in something with a lower rate than I can get in my online savings accounts.
I have been considering this approach as well and the big thing that is holding me back is the fact that interest rate on the 3-9 month CD’s is actaully the same or lower than that of the savings account. You mention that you are earning at least 1% in your saving account, but then you will be investing $500 in July, August, & September for less than 1%, so essentially you will be locking up $1500 at rates lower that your current savings account. Even the 6 & 9 month rates you mention are the same as my current savings account rate, so that’s another $2000 in July & August locked up and earning the same as the savings account. Doesn’t this kind of defeat the stated purpose you have in doing this in the first place?
I agree with the long term goal, and I will probably be doing the same thing, but not until the 3-9 month CD’s are earning more interest than the savings account options.
I don’t really agree that CD ladders are the way to go. I have cash in an online savings account, but I put the rest in Lending Club, where it’s been earning over 9% for a year now. With the advent of Lending Club and other alternative investment options that return a lot more, CD ladders aren’t worth the time and effort.
That may change if CDs start earning 5-6% again, but those days would seem to be a long way off at this point.
-Erica
Oh, I should add, with both the note trading platform and the ability to cash out the monthly payments that borrowers make, IMO Lending Club is actually more liquid than a CD.
Once the CD ladder is set up, there is NO more time and effort — mine’s been rolling along happily now for several years.
The main draw of a CD (to me) is for the safety and security of it.
There is no gamble involved – no risk of losing it….. unless of course the whole country falls apart – and then what does it matter anyway
It’s only one part of my investments – diversification being the key
Have to agree with Marci here, but Erica’s points regarding the attractiveness of Lending Club are valid. I would consider investing more there, but since I consider it just a notch below single stocks in terms of the risk involved, I wouldn’t risk portions of my emergency savings with Lending Club notes.
Nah, I wouldn’t either. I keep my EF in an ING Direct savings account. Came in handy at tax time. :-/
I have about 4 months’ living expenses (6 if I cut down on my expenses) in my EF. Lending Club is where I keep cash after that. I figure if the **** really hits the fan, I have a few months to liquidate my LC holdings. But at this point, it throws off over $1000/month in cash (principal repayments and interest), so I could just theoretically live off of that for a while, too.
Lending Club is great when you’ve filled up your emergency fund and are ready to do something else with the rest of your cash on hand. I find it less risky than the stock market, because each loan is generally uncorrelated…it’s not like holding INTC and MSFT and watching them both plunge on the same day because some other company in the same sector had a bad earnings report.
-Erica
Thanks for sharing this info! Sounds more like leap frog than a ladder but what the heck. I’ll make sure to do this once I free up some more money. Already got a couple of CDs but they are longer term. Short term ones next time.
It always amazes me how we want to be secure. The banks are raping you with their interest charges. Why don’t you take some of your money and buy Bikes and repair them and resale them FOR A PROFIT. Control your own money! Buy something and sell it. You will make far more than letting a bank take care of you! I save my money buy a car, hire someone to work for me and then get a 35 to 40% profit. Hire young people to help older people with yard chores. Don’t bet your security on a bank. Who got us into this crisis? THE BANKS AND STOCK MARKETS!!!!
I’ve always loved the idea of CD ladders, but with interest rates being so low, it feels like having the money more liquid is much more valuable, especially with interest rates practically at an all time low.
What goes into your decision process to determine whether it’s worth it to lose liquidity in return for higher interest rates? Based off your information it seems that an ING Direct Savings account which gets 1.1% APR is only .4% less than the CD that locks your money up for a year.
CD’s can be liquid, in a different form…. Most banks will let you borrow against your own CD for 1% or 2 % more than what your interest rate on the CD is….. That allows for a very low interest loan, should you need one for the short term. It’s not something that they tend to advertise tho
You’d need to ask about it!
hmm sounds pretty interesting. I’ll definitely look into that. Thanks for the tip!
i am personally not a fan of CD’s i have had them before and have been tied up with them to the point where i missed out on other investment opportunities so i hear where you are coming from on some of these points.
A bit late to the party but, would it be a good idea to define what “CD” stands for here? You start off with an acronym and continue to use it. Maybe it’s a US-only financial product(?) and not being American I’m missing something otherwise obvious but I think it would make your article better and clearer. Meant to be positive criticism btw
Thanks
Fair enough, and an excellent point! A CD is also known as a certificate of deposit, and is essentially a “time deposit.” They work very similar to a savings account, but instead of being able to withdraw money, you agree to keep the money on deposit for an agreed to length of time (6 months, 12 months, even up to five years and higher).
Generally, the longer the term the higher the interest rate offered by the bank.
What’s nice about this is you’re breaking your money up among several CDs, which is great for an emergency fund. If you dropped all your $6K into just ONE CD, the penalty for breaking it early, if needed, would ruin your return. But by dividing it up into many $500 (or even less if you want) CDs, if you just need a quick $400 for a car repair or $900 to cover a surprise bill, you only have to break one or two of the CDs, and you can keep the others going, saving you a lot of penalties.
CD Ladders are a GREAT way to hedge against interest rate changes!!
This strategy is a HOT topic on blogs right now, but it surprises me this aspect hasn’t been discussed. People seem to focus primarily on how money continuously turns over. But keep in mind it is a long term strategy, and it also works for bond investments as well (also popular now).
Putting it in terms of bonds (which can earn up to 4/5% if you go out far enough and don’t insist on AAA credit ratings), if you ladder with a portfolio of 1 year, 2 year, 5 year, and 10 year bonds, etc, you will similarly have money continuously turning over. All you need to do is reinvest in a 10 year bond. This also means that if interest rates rise 5 years out, you will have *some* money mature that you can invest at a higher rate.
Sure, its not as great as investing *all* your money at the higher rate, but not even the smartest of the smart can guess where rates will go *when* with precision. But if you follow a good laddering strategy long term, you will at least be sure that some of your money gets the best rate at the right time.
The flip side is equally attractive: if, in 10-15y interest rates decrease again (as is currently forecasted with an inverted yield curve), only *part* of your money will need to be reinvested in a low-rate environment (something that most consumers couldn’t otherwise strategize for)!