Over the years, certificates of deposit (CDs) have earned a reputation as being a low-risk way to earn interest on your money. But CDs come with a big downside: You typically can’t remove the money without a penalty. A CD ladder lets you invest in CDs at varying intervals, with each maturing at a different time so that you frequently have access to at least a portion of your money.
What Is a CD?
If you have excess money hanging around, you’ll probably want to find a way to make that money work for you over a specified period of time. You could invest it in the stock market, but that comes with risk. One wrong choice and you’ll lose the money you worked so hard to accumulate.
That’s where a certificate of deposit comes in. With a CD, you agree to leave the money untouched in an account for a fixed time period in exchange for a higher interest rate. Usually, interest rates will be higher in a CD, making it worth the inconvenience of not having access for six months or longer.
Pros of CDs
Although interest payouts can vary as the Federal Reserve adjusts the national interest rate, you’ll typically get at least a little more from a CD than a savings account. According to the FDIC, the going national rate for savings accounts is between 0.05 and 0.80 percent, where you can get a 60-month CD with a rate as high as 1.14 percent. When the interest rate increases, the difference can be even more dramatic.
But the best thing about CDs is that those interest rates are locked in. If you take a 60-month CD with a 1.14 percent interest rate today, you’ll enjoy that interest earnings for the entire 60 months. If you put that money in savings instead, your interest rate can drop the next month.
Cons of CDs
The biggest downside to CDs is the way it locks up your funds. Although you don’t have to go with long-term CDs, you'll find that the longer you’re willing to leave the funds untouched, the higher the interest earned. That said, you can find CDs with terms as short as one month, and sometimes those will pay more in interest than you’ll get from savings.
Interestingly, the same rate lock that makes CDs a good investment can also be a downside. If the interest rates decrease, being locked in works in your favor. But what happens if interest rates increase? You’ll be locked in, which means you’re stuck at the lower rate until your CD reaches maturity. That can be especially notable if you opt for a four- or five-year CD.
Read More: Certificate of Deposit Pros & Cons
What Are CD Ladders?
Laddering has become a popular way to make the most of the extra interest that comes with CDs. With this strategy, you open multiple CDs, each with different start and end dates. For instance, if you purchase a six-month CD today, then wait three months and purchase another six-month CD, you’ll have a CD expiring in six months and another in nine months.
If done correctly, you can reach maturity dates every few months. That reduces the risk that you won’t have to put off making a purchase for years because your money is tied up in a CD. You can apply this same strategy to longer-term CDs, having one maturing every year or so, even when you’re purchasing CDs that last for multiple years.
How to Build CD Ladders
Before you buy your first CD, stop to think about how you’re going to do things. Look at CD rates and calculate how much extra you’ll earn by purchasing a longer-term CD versus one that only lasts months.
Once you have your strategy mapped, you’ll be ready to purchase your first CD. Here’s an example of how it would work:
- This year you buy a 12-month CD
- In six months, you buy a 24-month CD
- Six months from that, you buy a 36-month CD
- Six months from that, you buy a 48-month CD
It will be a full year before your first CD matures in this scenario. At that point, you can decide whether to reinvest the money into that same CD for another year or put it into something longer-term, such as a two-year CD or even a five-year CD. You can do this with confidence because in another year, your second CD will mature, giving you access to that portion of your money.
Penalties for Early CD Withdrawal
CD laddering isn’t the only way to hedge your bets when it comes to investing in CDs. First off, it isn’t the end of the world if you have to withdraw your money before it matures. In most cases, you’ll simply forfeit some of the interest you’ve earned. Unless the United States is currently in a period of higher interest rates, this may not even be that much of a sacrifice.
Before you start coming up with a CD laddering strategy, first look at the penalty your bank charges for early withdrawal. According to NerdWallet, many banks charge you around a year of interest if you withdraw a five-year CD early, but a short-term CD only comes with three months or so of interest loss.
How to Buy CDs
Buying a CD is a surprisingly simple process once you’ve tracked down a lender. First look at the rates your own bank is offering. You may choose to stay there just to keep things simple. However, there is a benefit in dividing your money among multiple FDIC-insured institutions since FDIC insurance only covers up to $250,000 per depositor.
Once you’ve identified a CD you want to purchase, you’ll just need to follow the lender’s purchase process. You pick a term, then fund the CD. Often you can make this transfer online, although sometimes you’ll be required to complete paperwork that's mailed to you.
Another option is to bypass penalties altogether. You can find both long- and short-term CDs that let you access the money at any time. The problem with these CDs is that the interest rate may not be quite as high as one that requires you to leave your money alone for months or years.
So how is a no-penalty CD different from a savings account? Typically, the annual percentage yield (APY) is higher, which is one big difference, but the other is that your rate is locked in. Savings account interest fluctuates with the market, but your CD interest will remain the same until the CD reaches its maturity date.
Types of CDs
Even if you opt to go with a CD that has penalties for early withdrawal, you’ll have some decisions to make.
There are 10 types of CDs, each with its own method of earning interest.
- Traditional CD: This basic option earns interest at the rate specified for the term you choose.
- Bump-Up CD: If you notice your lender has raised its interest rates during your CD’s term, you can request a bump to the higher rate. Typically, lenders limit these CDs to one increase request per term.
- Step-Up CD: This type of CD automatically increases in step with interest rate increases at specified intervals during the term.
- Liquid (No-Penalty) CD: You won’t be assessed a penalty for early withdrawal. While interest on liquid CDs is typically lower than CDs with penalties, it’s often higher than a lender is paying on a money market or high-yield savings account.
- Zero-Coupon CD: With this CD, you won’t receive any interest payments during the term of the CD. On the date it matures, interest will be paid. One issue with this is that you’ll still have to pay taxes on the interest you accrue each year, even though you won’t have access to that interest. You can usually get a good deal on interest with these CDs.
- Callable CD: You’ll often find higher interest on callable CDs, which give banks the right to recall the CD if the interest rate drops. If that happens, you’ll be issued a new CD at the lower rate.
- Jumbo CD: This refers to the type of CD requiring a larger deposit. In some instances, rates are higher for jumbo CDs, but not always, so it’s important to shop around, even if you have six figures to invest.
- IRA CD: This term simply refers to a CD you purchase to be held in your IRA account. Although you’ll often see lower returns on this type of CD, it is less risky than other types of IRA investments.
- Add-On CD: With this type of CD, you can continue to deposit money toward it throughout its term. You may be limited to a certain number of deposits, so it’s not as flexible as a savings account.
- Foreign Currency CD: This is a riskier CD that has you investing in CDs in other currencies. You invest in US dollars (USD) and returns are converted from the foreign currency to USD. The global exchange rate can fluctuate, which can make this less lucrative than other types of CDs.
CD Ladders & Taxes
When you start laddering your CDs, it’s important to pay close attention to the tax implications of your purchases. As with other income you earn, the yields you earn on your CDs are taxed. This is taxed on a yearly basis, whether you’ve invested in a one-year CD or one that lasts for multiple years.
In other words, if you’ve invested in a three-year CD, you will receive a statement each year from the lender calculating the taxes you’ve earned that year. If you have multiple CDs earning money for you, that means you’ll need to pay taxes on the interest you earned on all of those CDs. The only way CD laddering complicates this is that you may get multiple forms if your CDs are with more than one lender.
Alternatives to CDs
Certificates of Deposit are only one savings vehicle. There are other options, some of which come with a bit of risk and some that aren’t risky at all.
For the risk-averse, a money market or high-yield savings account could work better. Both money markets and savings accounts will give you penalty-free access to your money, although traditionally withdrawals have been limited to six per month. That regulation was recently lifted, allowing you to make unlimited withdrawals from those accounts.
Ultra short-term bonds are another low-risk investment option, and they come with no withdrawal penalties, although it may take time to get your money when you need it. Series EE Savings Bonds are also notoriously low risk because they’re backed by the U.S. government. You can buy them through TreasuryDirect.gov in just a few simple steps.
Read More: The Best Time to Buy Bond Funds
A CD can be a great low-risk investment, but keeping your money inaccessible for months or years can be tough. If set up properly, a CD ladder can ensure you always have at least one CD expiring in the months to come, so at least some of your money is available to you in the short term.
- Business Insider: A CD Can Help Your Money Grow, But Right Now Might Not Be the Ideal Time to Open One
- FDIC: Weekly National Rates and Rate Caps - Weekly Update
- NerdWallet: CD Early Withdrawal Penalty by Bank
- Bankrate: Federal Reserve Lifts Six-Withdrawal Limit on Savings Accounts
- My Bank Tracker: Ultra Short-Term Bonds vs. Savings & CDs: Which Offer Better Returns?
- TreasuryDirect: Series EE Savings Bonds
- FDIC: Deposit Insurance FAQs
- Discover: How to Open a Certificate of Deposit (CD)
- Bankrate: 12 Types of CDs: Which One Is Best for You?
Stephanie Faris has written about finance for entrepreneurs and marketing firms since 2013. She spent nearly a year as a ghostwriter for a credit card processing service and has ghostwritten about finance for numerous marketing firms and entrepreneurs. Her work has appeared on The Motley Fool, MoneyGeek, Ecommerce Insiders, GoBankingRates, and ThriveBy30.