Laddering CDs

In my January 24 post ("Cash: The Least Sexy Part Of Your Portfolio"), I wrote about the various reasons why you might want to make cash a certain percentage of your investment portfolio, after taking into account your investment objectives and your tolerance for risk, among other things. Once you have settled on an amount for the cash portion, you typically have the option of putting the cash in a money market account, a government issued short-term security or a short-term certificate of deposit (a "CD"). All three can function as cash. This post addresses the issue of how to build a ladder for the chunk you're putting into CDs, particularly an initial mixture of short-term and mid-term CDs.

A CD is akin to a contract between you and a financial institution (the "Bank"), whereby the Bank agrees to pay you a little bit higher rate of interest on the amount deposited than it would be willing to pay on a regular savings account, provided you agree to keep that deposit untouched for a certain period of time. It is almost always true that the longer the term of the CD, the higher the applicable rate of interest. If you decide to "break the contract" by pulling your money out before the end of the term, you are assessed a monetary penalty. The penalty usually equals about 10% of the amount withdrawn. As you can see, therefore, an individual who is considering CDs has to balance the desire for a higher rate which usually comes with a longer term CD against its illiquidity. Because of the illiquid nature of even short-term CDs, a depositor should put some cash aside, apart from the funds going into CDs.

So, now that we've laid the groundwork, how do you set up a ladder? The goal of a CD ladder is to get to the point where you have a three-year (or if you prefer, a five-year) CD maturing every year. That point can be reached in three years, following these steps:

Step 1: Divide the money you are going to use for your CD ladder into three equal lots. With the money in Lot # 1, buy a one-year CD ("CD # 1"); simultaneously, with the money in Lot # 2, buy a two-year CD ("CD # 2"), and with the money in Lot # 3, buy a three-year CD ("CD # 3").

Step 2: After one year (or in other words, at the very beginning of Year # 2), CD # 1 will mature. Take the money from that matured CD # 1 and buy a three-year CD ("CD # 4"). Don't do anything with CD # 2 or CD # 3; they have not yet matured, so let them ride.

Step 3: After another year (or in other words, at the very beginning of Year # 3), CD # 2 will mature. Take the money from that matured CD # 2 and buy a three-year CD ("CD # 5"). Don't do anything with CD # 3 or CD # 4; they have not yet matured, so let them ride.

Step 4: After another year (or in other words, at the very beginning of Year # 4), CD # 3 will mature. Take the money from that matured CD # 3 and buy another three-year CD ("CD # 6"). Don't do anything with CD # 4 or CD # 5; they have not yet matured, so let them ride.

You have no doubt noticed that once you have completed Step 3, you will have a three-year CD maturing every year going forward, and when that happens (i) you take the money from that matured CD and buy a new three-year CD, and (ii) you let your other two CDs ride because they have not yet matured. That, boys and girls, is what we call a "CD ladder." The beauty of a ladder is that you are getting the benefit of a higher rate for a three-year commitment than you would for only a one-year commitment, but you are investing at regular annual intervals instead of three year intervals. As noted above, you could set up a longer-term (say, five-year) ladder instead of a three-year ladder, but then the issue of liquidity merits even more consideration. Plus, it is not always easy to find an acceptable five-year CD.

Two other related items. First, you do not have to buy all your CDs from the same Bank. Check out the website "bankrate.com" for a search of banks offering the best deals. The search can be run locally or nationally. Second, although this is beyond the scope of this post, you should be aware that some investors use the ladder concept for bonds, as those instruments can also be found in terms of different lengths.