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CD Laddering

CD laddering is a way to dollar cost-average your CD portfolio to smooth and hopefully maximize your CD return over a period of years.  Like dollar cost averaging, you don’t buy just one CD for one term, but instead buy multiple CDs over various timeframes to take advantage of the rate premium in longer-term CDs and to reduce the risk of interest rate changes.

The basic premise of CD laddering is to always have a CD that is coming due in 1 year.  Here’s an example for how this could work.

Non Laddered CD Investing

Suppose you have $100,000 to invest.  You could invest the entire amount in a 1 year CD and then reinvest it every year in a new 1 year CD with hypothetical rates shown in the chart below:

 

Period	Rate
Initial Investment	5.55%
End of Year 1	5.80%
End of Year 2	5.30%
End of Year 3	4.75%
End of Year 4	6.20%
End of Year 5	3.70%

As you can see, the return starts off okay but at the end of the fifth year hypothetical interest rates drop and you’re stuck investing at 3.7%

CD Laddering

You could also break the $100,000 into 5 different investments and place $20,000 each in different term CDs.  This is CD laddering.  At the end of each year as the 1 year CD expires, you would invest that into a 5 year CD and put it at the end of the line.  Then, the next year, another CD would mature and you would roll that into another 5 year CD.  In this way, a CD would mature every year and give you the opportunity to invest the money fresh.

The chart below shows a hypothetical first year and second year CD laddering structure.  Note that on the Year 2 chart, the original first year CD has moved off, each CD has moved up, and there is a new 5 year CD.

This would keep running as long as you want, and you’d continue to let the 1 year roll off and replace it with a new 5 year.

The advantage of this cd laddering approach is that it allows you to spread your interest rate risk and to take advantage of higher rates on longer-term CDs.  The chart below shows the hypothetical returns when comparing laddering to a non-laddering approach.

CD Laddering Versus Non-Laddering Comparisons
	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6	Total
Return
Laddering	$5,388	$5,408	$5,430	$5,372	$5,580	$5,300	$32,478
Non-Laddering	5,550	5,800	5,300	4,750	6,200	3,700	$31,300
Difference	(162)	(392)	130	622	(620)	1,600	$1,178

The laddering approach generates an additional $1,178 dollars over a 5 year period, mainly because laddering cushions an investor from the steep drop in rates in Year 5.  As you can see, in some years the laddered approach does better and in other years the non-laddered approach wins.  This will depend on interest rates.  If rates are high one year, then with the non-laddered approach the entire $100,000 can be invested at this high rate while some of the laddered money is earning a lower rate.  The spread between the different term CDs also makes a difference.  If 5 year CDs are not paying much more than 1 year CDs (as is the case now – August 2007) then the benefit of laddering will be reduced.

What laddering does do is smooth out your earnings potential.  If rates are high today but drop precipitously in one year you will still have some higher yield, longer term CDs in your portfolio to boost your earnings.  So instead of having to invest $100,000 at a low rate in a year, you would only have to invest $20,000 in a low rate and the remaining $80,000 would be at a higher rate.

One disadvantage to laddering is that your money is not as liquid.  With the non-laddering approach your entire $100,000 comes due every year while with laddering this amount is only $20,000.  While you can withdraw money from a CD whose term has not come due, you’ll also have to pay some hefty penalties that will wipe out any return advantage.

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