Can a CD Ladder Help You Build Wealth?

Certificates of Deposit (also known as CDs) can serve as a safe spot to park your money. Especially for those who tend to be slightly more risk averse, CDs offer a better earnings rate than regular savings accounts while providing the same level of security. So, how can a CD ladder help you to build wealth?

A CD ladder is a technique that can be employed to take advantage of the relatively high interest rates of CDs while giving you access to your money at regular intervals. In this sense, a CD ladder offers both security with flexibility. Depending on your personal preferences, it could be a good strategy to help you build wealth.

How Does a Certificate of Deposit Work?

Before diving into the details of a CD ladder, it is important to understand how CDs work. A CD is a type of savings account that earns a better rate than a standard savings account.

Banks and credit unions offer CDs in order bring in money to their institutions. They benefit by having a guaranteed source of funds available for set periods of time, which allows them to extend more credit via loans to their customers.

For consumers, a CD is a fairly straightforward proposition. In exchange for committing your money for prespecified amounts of time, you will receive a higher guaranteed savings rate. These rates will depend on overall market conditions and interest rates, and will also vary by institution. (Online-only banks can often offer better rates, as they do not have the same infrastructure costs as their bricks-and-mortar counterparts.)

CDs are safe investments, and your money is federally guaranteed for up to $250,000 as long as CDs are from banks that are FDIC-insured or credit unions that are NCUA-insured.

There are essentially two types of risks that owners of CDs must face: (1) opportunity costs and (2) lack of liquidity. By opting to go with a CD, you are locking in your savings rate. While this has certain benefits, you are also forgoing potential gains from equities if a bull market takes off or from other savings opportunities if interest rates rise. In addition, opening up a CD essentially puts your money aside for a predetermined period of time. If an emergency arises and you need access to cash fast, you will usually be forced to pay a penalty for withdrawing your money before the maturity date.

What is a CD Ladder?

A CD ladder is essentially a combination of a number of different CDs that will mature at different periods of time.

There are multiple ways to go about creating one. For instance, if you have $5,000 that you wish to place in CDs, you could open five different CDs for $1,000 at 1-year, 2-year, 3-year, 4-year, and 5-year intervals.

After the first year, when your first CD matures, you would place the balance into a 5-year CD. After the second year, when your second CD matures, you would once again place the balance into a 5-year CD. You would continue this cycle, creating a scenario where every year you will have a 5-year CD that matures.

Via this savings structure, you will have built a “ladder” whereby you are earning guaranteed amounts of money while having the flexibility to remove your funds from the cycle at predefined exit points every year.

While the same risks involving CDs outlined above remain, they are minimized since every year you will have the option to find greener pastures for your funds. In a similar fashion, the risk of being forced to pay a withdrawal penalty will be less acute since you will have at least one opportunity to access a portion of your funds–penalty free–on an annual basis.

Variations on the CD Ladder Theme

Like any savings or investment vehicle, there is always a trade off surrounding risk versus reward.

Depending on your risk profile, you may wish to structure a CD ladder slightly differently. There are a number of options for doing so. These include:

(1) Mini CD Ladder: If 5-year horizons are too long, you can create a CD ladder with shorter maturity timeframes. The key is to make sure that your various CDs are maturing at different points of time, which can be every few months if that fits your financial goals. (Interest rates are generally lower with short-term CDs.)

(2) Barbell CD Ladder: Having a CD mature every year may not be a priority for you. In this case, you could divide your savings into short- and longer-term CDs. Though you will effectively be skipping over the middle rungs of your CD ladder, this will allow you to enjoy the benefits of longer-term savings rates while also ensuring that your short-term liquidity needs are met.

(3) Bullet CD Ladder: While it is often grouped with other types of CD ladders, this strategy is actually the opposite approach of a traditional CD ladder. With a bullet CD strategy, you will utilize CDs of different timeframes but that all mature around the same date. This is a good strategy to pursue if there is a specific purchase you are gearing up for, and it will allow you to simultaneously devote money towards this goal while (potentially) taking advantage of higher short-term savings rates if interest rates rise.

Conclusion: One Option Among Many

Using CDs can help you grow your savings over time, especially as compound interest begins to work its magic as the years tick by. If concerns about locking up your money in CDs are giving you pause, you can consider creating a CD ladder that will enable you to have ready access to your funds at regular intervals.

Of course, the other major trade off of placing your money in CDs is the fear of missing out on skyrocketing gains in the markets. (FOMO is a powerful force in every facet of our lives.) The best approach to building up wealth over time is a diversified strategy, one that utilizes both savings and investments.

CD ladders can be a component of sound financial planning. They are one option among many possibilities, combining long-term planning, guaranteed savings, and flexibility.

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