Lets say you bought a 5 year CD paying an interest rate of 2%. Then a year later interest rates rise and a new 5 year CD is paying 4% interest. Because you have 4 years left on your existing CD, you are effectively “missing out” on the additional 2% of interest being offered to purchasers of new 5 year CDs.
In this example, you might have been better off waiting a year to buy the 5 year CD. As interest rates are close to historic lows, there is a major concern among CD buyers that they may miss a major upswing in interest rates when buying longer term CDs.
So what are some potential solutions to this problem?
First you could withdraw the money from the CD early, to invest at the new higher rate. As there are serious penalties for doing so, a better option might be to buy short term CD’s. This way if interest rates rise, you only have your money tied up in the lower yielding CD for a short period of time. When the short term CD matures you can invest the proceeds in a longer term CD, at the new higher rates.
Shorter term CD’s almost always pay a lower rate of interest than longer term CD’s. As a result of this, buying shorter term CDs could be expensive in terms of the potential interest that you forgo while waiting for rates to rise. With this in mind, many people purchase of a combination of shorter-term and longer-term CDs. This gives you the benefit of additional interest on the portion of your money put into long term CD’s, and the flexibility to take advantage of any short term interest rate increases with the money you put into the shorter term CD’s. This is the concept of Laddering.
Lets say you have $10,000 that you want to invest in a CD. To create a CD ladder you could break that $10,000 into 5 separate $2000 investments which are invested as follows:
- 1 Year CD: $2000
- 2 Year CD: $2000
- 3 Year CD: $2000
- 4 Year CD: $2000
- 5 Year CD: $2000
After setting up the above ladder, at the end of the first year and each year after, one of your CD’s would be maturing. Assuming you do not need the money at the end of the year, and in order to keep the ladder going indefinitely into the future, you invest the proceeds into a new 5 year CD.
Creating a CD ladder is not only a good way to remain positioned to benefit as interest rates change, but also a great way to create a stream of money at specific times, when it may be needed to pay for things such as education expenses.