A CD ladder is a type of savings account investing strategy. It’s a strategy designed to enable an investor to maximize return on investment (ROI) with the higher interest rates offered on longer-term certificates of deposit, while also enjoying the benefit of easy access to invested capital.

A CD ladder consists of a portfolio of several CDs that have varying maturity dates. The staggered maturity dates mean that you have a regular, periodically recurring option to withdraw some of your investment capital, should you need it or want to invest in something else.

Understanding Certificates of Deposit (CDs)

A certificate of deposit (CD) is essentially a “time-locked” savings account. In return for keeping money invested in a CD for a specified period of time, a bank or credit union is willing to offer you a higher interest rate than what they ordinarily offer on a standard savings account.

The term lengths for CDs vary, with commonly available term lengths as short as three months, up to as long as five years. Long-term CDs usually pay higher interest than short-term CDs.

If you withdraw the money invested in a CD prior to its maturity date, then you incur an interest penalty. Early withdrawal interest penalties are usually figured in terms of “days of interest”. For example, if you withdraw your money from a five-year CD before maturity, your bank might subtract 180 days’ worth of earned interest. Thus, if you withdraw your money after four years, you’d only receive three and a half years’ worth of interest.

By using CDs with different terms and maturities, a CD ladder investing strategy reduces your risk of early withdrawal penalties.

What is a CD Ladder

A CD ladder is simply a portfolio of multiple CDs that have different maturity dates. Holding CDs with varying maturities offers the following benefits:

• It lowers the risk of having money locked into a low interest rate CD if interest rates should rise
• It also reduces your risk of missing out on the chance to earn higher interest rate returns if prevailing interest rates fall

Although some CDs are variable rate CDs, most are fixed rate investments. If you’re earning a high fixed rate on a five-year CD, and prevailing interest rates fall during the term of your CD, you’ll benefit from having locked in the higher rate.

How to Create a CD Ladder

A typical CD ladder is made up of five “rungs” of CDs, with maturity dates ranging from one year to five years.

As the image below illustrates, you create a five-rung CD ladder by making the following five initial investments (for this example, assume the total amount of investment capital committed to your CD ladder is $5,000):

• Invest $1,000 in a one-year CD
• Invest $1,000 in a two-year CD
• Invest $1,000 in a three-year CD
• Invest $1,000 in a four-year CD
• Invest $1,000 in a five-year CD

As each of your five initial investments matures, you reinvest the funds in a new five-year CD. So, at the end of your first year, when your one-year CD matures, you reinvest that money in a five-year CD.

You then hold –

• A two-year CD maturing at the end of the next year
• A three-year CD maturing in two years
• A four-year CD maturing three years from now
• A five-year CD that matures in four years
• An additional five-year CD that matures five years from now (the five-year CD you invested in with the funds from your original one-year CD)

At the end of four years, all your shorter term CDs will have matured, and you will then have five five-year CDs – with one of the five reaching maturity each year. You can maintain your CD ladder as long as you like. You can also opt to start a new ladder, again purchasing five CDs with maturity dates from one year to five years.

Note – Compounding Returns: Whenever one of your CDs matures, you can choose to pocket the earned interest and just reinvest the principal amount. However, you can get the benefit of compounded returns by reinvesting the total of your original principal, PLUS the interest you earned. For example, if you invest $1,000 in a five-year CD paying 3% interest, at maturity your CD will have earned $159.27 in interest. If you reinvest just the $1,000 principal, then you will again earn $159.27 interest in five years. However, if you invest your principal amount and your earned interest – $1,159.27 – then at the end of the next five years, you will have earned $343.91 in interest. That’s more than double the $159.27 you earned the first five years. Roll it all over again, and the next five years will earn you $557.96 in interest.

📊 Note – Different Types of CDs: You can populate your CD ladder with different kinds of CDs. For example, “callable CDs” offer higher yields, but give your bank a call option to pay you off and cash out the CD before it has run its full term. “No penalty CDs” pay lower interest rates, but don’t carry any early withdrawal interest penalties. Thus, they give you significantly increased liquidity.

Because of varying rates offered, you may want to create a CD ladder that is initially made up of CDs from different banks. One bank may offer the best three-year rate while another offers the best four-year rate.

When to Use a CD Ladder Strategy

There are two main circumstances that may make a CD ladder strategy a wise move.

• Interest Rate Uncertainty
  A CD ladder, with varying interest rates spread across different maturities, may work to your advantage when there is a high level of uncertainty regarding future interest rates. The ladder gives you flexibility. You can easily make adjustments to your CD portfolio with the rolling maturity dates in a CD ladder. The flexibility of a CD ladder also offers you the option to easily move your investment capital into other investments as your CDs reach maturity.
• Wanting More CD Liquidity
  Some investors employ a ladder strategy when they don’t want their savings tied up for a long period of time. With a five-rung ladder, every year you have the ability to cash out 20% of the capital you have invested in CDs, without suffering any interest penalties. Why is that a desirable option? – Perhaps you believe that you might incur some unexpected expenses in a year or two, so you want the option to access at least part of your savings deposits.

Do you want even more CD flexibility and liquidity? – Consider constructing a 10-rung CD ladder, with one CD reaching maturity every six months, as opposed to the “one-a-year” maturities a five-rung ladder offers.

Another circumstance where you might find using a CD ladder advantageous is if you anticipate wanting to move some of your investment capital into alternative investments that offer a potentially higher rate of return. Perhaps you expect your income to increase substantially within the next few years. That may raise your level of risk tolerance. You may then be willing to commit more money to higher risk investments that offer correspondingly higher potential profits.

Why – or Why Not – to Construct a CD Ladder: Advantages and Disadvantages

Every possible investment choice that you make will always have relative advantages and disadvantages. There are always trade-offs in choosing one investing strategy over another. Every investment carries an “opportunity cost”. Opportunity cost simply refers to the fact that whenever you choose to commit investment capital to one investment, you forgo the opportunity to invest it elsewhere.

The concept of opportunity cost is one of the factors that makes the flexibility of a CD ladder attractive. Should a much more appealing investment opportunity arise, a CD ladder, as already noted, gives you the regular, recurring option to cash out part of your CD holdings and transfer money into a different investment.

CD Ladder Pros

There are several basic advantages to constructing a CD ladder. First, it’s an easy means of earning a higher interest rate than what your bank offers with a traditional savings account or interest-bearing checking account. Second, because CDs are usually fixed rate instruments, they provide a predictable amount of interest income. Third, a ladder of CDs enables you to earn higher returns than you could make by investing all your money in a single short-term CD. But you still have liquidity similar to that offered with short-term CDs.

A CD ladder may offer a path that meets your short-to-medium term savings goals or needs. CDs work well as an investment vehicle when you’re saving for a specific purpose and within a timeframe – for example, if you’re saving money for a down payment on a house you hope to buy in a few years.

CD Ladder Cons

The primary disadvantage of a CD ladder is that even the highest-yield CDs offer a relatively low rate of return. Savings accounts of any type rarely, if ever, offer returns high enough to overcome the rate of inflation. However, CD investors are typically more concerned with making an investment that’s “safe”, rather than one that offers significant wealth-building opportunity.

Final Thoughts

CD laddering doesn’t require you to follow a strict, rigid structure. You can vary maturity intervals, how many rungs your ladder has, and how much money you invest in each CD. Construct a ladder that suits your personal financial goals, investing strategy, investment time horizon, and risk comfort level.