Why a CD Ladder is an essential pillar of your wealth building strategy
Typically when you hear of the keys to building wealth, you’ll hear terms like compounding interest, start early and the stock market always goes up over time. Well, today, I’m going to explain why the CD ladder is just as important as these other keys to building wealth. In fact, I’d argue that the CD ladder is one of the most foundational strategies you can implement in your financial planning. By implementing the CD ladder, you better enable the other wealth building components of your strategy to flourish.
In this CD ladder guide, we’ll discuss the following (you can click on the link to jump to the section):
- What is a CD ladder?
- Why is the CD ladder so important?
- Emergency funds & CD ladders
- How to build a CD ladder with examples
- CD Ladder Calculator
- Different types of CDs
- CDs you should consider opening now
- How are CDs taxed?
- Bonus: What is a bond ladder?
What is a CD ladder?
Before we get into the CD ladder, let’s first talk about what a CD is. CD refers to Certificate of Deposit (CD). The CD is an investment product where the investor allocates a chunk of cash for a specific term at a fixed interest rate. For example, a 12-month CD is quite common as are CDs of longer duration such as 2-year, 3-year, 5-year, etc.
CDs are attractive because it is extremely safe and offers a better return typically than a checking or savings account. The rates are higher because you are agreeing to have your money locked up for the duration of the CD. CDs are usually guaranteed and federal insured by the FDIC.
What if you need the money before the CD matures? It’s no problem, you can get access to the money, but you do incur a penalty typically. The penalties typically aren’t too harsh, and are often a month or several months of interest that you gained. So if you cancel a 12-month CD nine months in, you will get the money but might have to pay back three months of interest from the CD, so you would essentially get your money back plus six months of interest (instead of nine months of interest). When you are shopping for CDs, you should typically examine the early withdrawal penalties so you know the penalty in the event you need to access the money early.
The components of a CD are typically as follows:
- Interest rate: A fixed interest rate gives you assurance that your cash is earning a return. Once you enter into the CD, the bank cannot change this rate on you. The rate can change with respect to CD renewal when your CD matures (when the year is up on a 12-month CD, if you want to roll over the money into a similar CD, the interest rate might be different than it was a year prior).
- The term: The length of time that you commit to leave your funds deposited. The term ends when the CD “matures.” If you wish to withdraw your money sooner, you often incur an early withdrawal penalty.
- The principal: This is the amount of money you are depositing into the CD.
CDs are available are just about any financial institution or bank. Often times the best CD rates are available with online banks. We love building CD ladders via the online offerings in order to get the best rates (more on this later).
Is there any downside to owning a CD? The negatives are minimal and straightforward. The risk of having money locked up in any fixed income instrument is that interest rates might rise while your money is locked up and therefore, you’re now earning a lower rate of return than market interest rates. Note: the CD ladder addresses this risk.
Moreover, CDs will typically earn a lower rate of return than stocks and corporate bonds. This is because CDs have essentially zero risk of losing principal (while stocks and bonds can lose value). This isn’t really a risk, but just an important element to note as it dictates how CDs are just one part of an overall financial and investment strategy.
So, let’s get into a bit more strategy. When it comes to CDs, the main strategy is the CD ladder.
A CD ladder is when an investor takes a sum of money and divides it into multiple CDs with different maturity dates in order to both maximize flexibility and maximize return at the same time. Rather than putting a lump sum of money into a single CD, a CD ladder reduces the risk that the investor will miss out on better interest rates before the single CD matures. The CD ladder also reduces the potentially penalties incurred should the investor need to access the cash before the CD matures since the investor can access the capital of one of many CDs, rather than the CD that houses all of his or her cash.
Why is the CD ladder such an important piece of your financial plan?
Unless you inherit a ton of money, sell a business for millions or have an insanely high income, your path towards getting quite wealthy will follow the path of methodical saving and investing over time. There are two keys to this approach leading to millions of dollars later in life. These keys are:
- Ensuring you have appropriate cash on-hand to weather unforeseen expenses. These expenses can be big or small. It might be a $500 repair bill on your air conditioner. Or, it might be a $25,000 medical bill that for some reason isn’t covered by insurance. The reality is that life happens to all of us, and there will be times when you get hit by unforeseen expenses. A hugely important key in being successful financially is to be able to absorb these hits without it interrupting the rest of your financial plan.
- Letting your investment portfolio run. Regardless of what your asset allocation is (whether it be 100% stocks or 60% stocks and 40% bonds), the important thing is to let it do its job. We have literally a hundred years of data on what to expect annual returns to be for various allocations. Trust this data. Let your portfolio run. Keep putting money into this portfolio whenever possible. Don’t take money out, and don’t overthink it. Let your investments run. You’ll get extremely wealthy by doing LESS.
It’s rare that one financial plan implementation can have a profound effect on both of these keys to getting wealthy, but the CD ladder does just that. A CD ladder addresses key no. 1 by ensuring you have appropriate liquidity to weather whatever life throws at you. The laddering process ensures that we’re getting as much return as possible for this cash while maintaining flexibility to pay for expenses if and when they come up.
The CD ladder addresses key no. 2 because the appropriately funded CD ladder helps you keep hands off your investment portfolio in a couple ways. First, as we mentioned before, the liquidity means you can manage unforeseen hiccups in life without touching your investment portfolio. The cash in your CDs and cash balance is there to use in an emergency. You can tap this money rather than selling stocks in your investment portfolio. But more than that, this CD ladder also helps calm you in the event of market turmoil which is affecting the values of your investment portfolio.
One of the hardest things to do in investing (and one of the most important for long-term gains) is to maintain cool when your equities have taken a 35% haircut during a market crash. But having a CD ladder that has not only not gone down in value at all, but is still generating a return according to its fixed interest rate, will help you weather the storm. The CD ladder can provide ballast for your overall financial picture and help you stay the course.
Emergency funds & CD ladders
We just mapped out how the CD ladder is part of the emergency fund concept. How much of an emergency fund do you need? Should your entire emergency fund be in a CD ladder? These are good questions worth addressing in detail.
How much of an emergency fund do you need?
There are many rules of thumb out there with respect to how much your emergency fund should be. For example, if you follow the Dave Ramsey approach, your first goal in getting your financial house in order is to get $1,000 in an emergency fund. Then after getting out of debt, your goal is to beef up that emergency fund to three to six months of expenses. The three to six months range is a decent starting point, but I think you need to go further.
First, if you are young and single, three to six months is probably sufficient. After all, you have no dependents and you can be fairly resilient when life throws you some challenging circumstances. For instance, when you’re 24 and you lose your job, you can sleep on a buddy’s couch for a period of time if need be.
The more dependents you have and the more obligations you have, the larger your emergency fund should be. Dependents typically means a spouse and children. Other obligations might mean helping out an ailing, elderly parent or simply a mortgage payment. For someone in their 40s with a mortgage and multiple kids, the emergency fund is more important than it is for a single 20-something, and the amount it is funded should reflect that importance.
Additionally, you should factor in the stability of your income. If you’re in a job where job security is very minimal, you might consider a larger emergency fund since job loss and income loss could happen at any time. If you have a ten-year guaranteed contract at your position and income loss isn’t even a consideration, then your emergency fund balance can reflect that as well.
I have a large family (five kids). We often have a range of random expenses hit. As such, I believe in a larger emergency fund than most. I like the security. As my kids go off to college and we transition towards an empty-nester part of life, I can take that emergency fund down a bit and allocate it into higher return investments. For now, my goal is to be in the six months to one year range of expenses. Now, interestingly, in 2020 with the coronavirus market crash, I took down the emergency fund to about three months of expenses because I wanted to put more money into play into stocks after taking a 35% market hit. This panned out pretty well, and since then, I’ve been working on building back up that emergency fund.
I share this personal example for a few reasons. First, your situation can vary from others. The emergency fund is an academic concept, but it’s also emotional and it’s meant to give you peace of mind. Fund your emergency fund to levels that suit your needs. Secondly, I’m aiming to show that while I believe if a fairly hefty emergency fund balance, I’m flexible with it as I used some of that cash to buy stocks during a major market downturn. This wouldn’t make sense for everyone, namely because often times market downturns happen in conjunction with economic recessions and potential job loss, but I knew in my situation that my income was stable.
Should your entire emergency fund be in a CD ladder?
We’re going to get into some specific CD ladder examples later in this guide, but let’s address this question briefly. I believe the answer here is no. But I think most of your emergency fund should be in a CD ladder. For example, if your emergency fund is $10,000, perhaps you have $2,500 in a savings account and $7,500 in your CD ladder.
Or if your emergency fund is $50,000, maybe you have $5,000 in cash and $45,000 in your CD ladder. This scenario would let you use the cash balance from a savings account for a wide range of unforeseen expenses (things such as braces for your child, an insurance deductible, a tax bill, etc.). If you deplete the $5,000, then you can let your next CD mature to replenish the $5,000 savings account balance rather than renew the CD. Then over time, build back up that balance back up to $50,000. Since this is a decent sized emergency fund, having an emergency fund of $45,000 instead of $50,000 for a while probably isn’t going to harm anything.
How to build a CD ladder (with examples)
Building a CD ladder is a simple, multi-step process. First you need to decide how often you want your CDs to expire. A common approach is to have a CD mature every year. I actually think this is too infrequent as much of this money is to be considered an emergency fund. So, I prefer the every six months approach. Let’s look at both examples.
CD ladder with CDs maturing every six months
When building a CD ladder, you need to figure out how many CDs you want to divide your total investment into. For every six months, I’d recommend six buckets. So instead of buying a single CD with all your money, you’re going to buy six CDs of equal amount. For this example, we’re going to use a sum of $20,000.
Here are the steps:
Step 1: Initial Investment – The first step involves buying six CDs all at once with equal amounts with maturities that will hit every six months from now.
- $3,333 in a six-month CD
- $3,333 in a one-year CD
- $3,333 in a 18-month CD
- $3,333 in a two-year CD
- $3,333 in a 30-month CD
- $3,333 in a three-year CD
Step 2: Renewal into longer-term CDs – The second step involves renewing every CD as it matures into a longer-term (three years in this example) in order to maximize higher interest rates of longer duration CDs, but maintaining the sequence of maturities every six months.
- Six months from now: Renew the six-month CD into a three-year CD
- One year from now: Renew the one-year CD into a three-year CD
- 18 months from now: Renew the 18-month CD into a three-year CD
- Two years from now: Renew the two-year CD into a three-year CD
- 30 months from now: Renew the 30-month CD into a three-year CD
- Three years from now: Renew the three-year CD into a three-year CD
After this renewal process, you now have CDs all maximizing higher interest rates of a longer duration of three years, plus you can pull out 1/6 of the total balance of the CD ladder every six months without penalty if need be. Of course, you can always pull out more money as needed while foregoing a few months of earned interest (as the early withdrawal penalty).
CD ladder with CDs maturing every year
For a CD ladder with annual maturation, I’d recommend four buckets. So instead of buying a single CD with all your money, you’re going to buy four CDs of equal amount. For this example, we will again to use a sum of $20,000.
Here are the steps:
Step 1: Initial Investment – The first step involves buying four CDs all at once with equal amounts with maturities that will hit every every year moving forward.
- $5,000 in a one-year CD
- $5,000 in a two-year CD
- $5,000 in a three-year CD
- $5,000 in a four-year CD
Step 2: Renewal into longer-term CDs – The second step involves renewing every CD as it matures into a longer-term (four years in this example) in order to maximize higher interest rates of longer duration CDs, but maintaining the sequence of maturities every year.
- One year from now: Renew the one-year CD into a four-year CD
- Two years from now: Renew the two-year CD into a four-year CD
- Three years from now: Renew the three-year CD into a four-year CD
- Four years from now: Renew the four-year CD into a four-year CD
After this renewal process, you now have CDs all maximizing higher interest rates of a longer duration of four years, plus you can pull out 25% of the total balance of the CD ladder every year without penalty as needed.
Mini CD Ladders
If you do research on CD ladders, you’ll occasionally see the concept of a mini CD ladder. Mini CD ladders refer to CD ladders with shorter-term CD durations. The example above of a CD ladder with CDs that mature every six months can be considered a mini CD ladder. Moreover, it’s not uncommon for some people who want ultimate flexibility to build a mini CD ladder with CDs that mature every three months. You could do this by doing four buckets (three months, six months, nine months and one year). Then the renewal step is all one-year CDs. This lets you get into a situation where you have four one-year CDs with one maturing every three months.
CD Ladder Calculator
Curious to see how a CD ladder’s return differs from a series of single CDs that rollover each year? You can use this CD calculator to check out the differences. Put in the total amount you wish to invest in the first input, then feel free to adjust the interest rates below (we started with some basic interest rate assumptions) to tweak the results.
Total amount to invest:
Single CD Rollover total after four years:
CD Ladder total after four years:
Additional earnings as a result of using CD Ladder:
Different types of CDs
While most CD ladders deal with tradition CDs, let’s do a brief overview of the various types of CDs you might encounter.
The traditional CD is the CD type with which investors are most familiar. The traditional CD involves a fixed interest rate and a specific term. When the CD matures, you usually have the option to renew the CD at the rate available at that time.
A bump-up CD is useful for benefitting in an environment of rising interest rates. If you open a bump-up CD, and the bank offers a better interest rate on the same product prior to the CD maturing, you can request that the bank change the rate on your CD to the better rate. For this type of flexibility, the beginning interest rate on the product is usually a bit less than that of a traditional, fixed interest rate CD.
The no-penalty CDs (sometimes called liquid CDs) have become more common in online CD marketing. It often involves some sort of shorter term or odd term CD in order to bring in new customers. The no-penalty CD means that you can withdraw your money early on the CD before the term ends without any penalty. The added flexibility without penalty might mean a lower interest rate than a traditional CD.
A callable CD means that the bank can “call back” the CD in the event that interest rates drop. If the bank finds they’re paying you a higher interest rate than currently available in the market (for instance on a long-term CD), they can call the CD and essentially make it mature early. Then you can open a new CD at the current market rate (lower). Callable CDs might come with higher interest rates initially since the bank has more flexibility with it (and they’ll pay you for that flexibility).
You purchase brokered CDs through a brokerage account similar to how you buy stocks and bonds. This can be attractive since you don’t have to open new accounts at other institutions. Also, you can trade them so they are more liquid. It’s very similar to trading bonds.
The jumbo CD involves a larger deposite – often times $100,000. While the jumbo CD might pay a higher interest rate than a traditional CD, it’s typically not a huge difference.
The IRA CD is a CD purchased inside of an Individual Retirement Account (IRA). It can make sense for older people or currently retired individuals to put retirement assets in a safe, guaranteed investment such as a CD. Typically, younger investors wouldn’t put long-term retirement capital into a CD.
CDs you should consider opening now
How are CDs taxed?
CD income is taxed similarly to interest income on a savings account. The specific point that some CD investors may be unaware of is that. youhave to pay taxes on earned interest even if you haven’t received the actual cash of that interest yet. For example, if you have a multi-year CD and you aren’t receiving the earned interest as a payment or check along the way (instead the balance of the CD is growing), you will have to pay taxes on this interest each year even if the CD hasn’t yet matured and even if you haven’t received the money.
Another interesting situation can come when you incur an early withdrawal penalty. The penalty can offset the interest earned, and in some cases can even be more than the interest earned (usually in the event that the CD is canceled pretty soon after opening).
Your financial institution will provide a 1099-INT form to include with your taxes. The 1099-INT will outline the interest earned that is taxable. It will also include details on the early withdrawal penalty if incurred.
For specifics, be sure to consult a tax professional.
What is a bond ladder?
A bond ladder is a portfolio of individual fixed income securities that are set to mature at different dates or different intervals very similar to the idea of a CD ladder. Bond ladders are a bit more complicated compared to CD ladders simply because it requires a bit of knowledge and experience in buying and trading individual bond instruments. Bonds usually refer to government debt (US treasuries), municipal debt (local governments and things like freeways) and corporate debt.
The world of bonds is vast with a myriad of different types of debt. It can be overwhelming for beginners. If you’re looking to add fixed income into your investment portfolio, most new investors will opt for a bond fund or a bond ETF where they can gain exposure to a number of fixed income instruments inside a single fund that trades similar to a stock.
Frequently Asked Questions
Is a CD ladder a good idea?
A CD ladder is a great tool for building a safe, reliable investment return. The CD ladder is advantageous over a single CD because it enables the investor to take advantage of higher interest rates with longer duration CDs while maintaining flexibility and regular access to capital.
How do I make a CD ladder?
The process is simple. Rather than put your money into a single CD, split it into even buckets. Then open a set of CDs with staggered maturity dates. As each matures, renew each as a longer duration CD (such as 4 or 5 year). At this point, you’ll have multiple CDs at higher interest rate, longer duration CDs but with one expiring each year or so.
Should I invest in CDs or bonds?
Both CDs and bonds are considered fixed income, however CDs are guaranteed against loss of principal where bonds can incur losses. Bonds typically have a higher rate of return to compensate the investor for the additional risk. Both bonds and CDs have a place in an overall financial plan. CDs are a good place for a portion of one’s emergency funds.