by Amy Lillard
(3/4/2013) Certificates of deposit (CDs) are safe and fruitful methods of building savings. In exchange for leaving the deposited money untouched for a certain maturity term (ranging from weeks to years) you can earn a higher rate of return than typical savings accounts.
To maximize your return even more, many savvy savers engage in a technique called “CD Laddering.”
Laddering is based on thinking strategically about different terms and interest rates. Those who use CD ladders split their funds into multiple CDs with varying terms. For example: an investor may divvy up their money to deposit into 5 CDs like so:
• $2,000 in 1-year CD at 3% return
• $2,000 in 2-year CD at 3.5%
• $2,000 in 3-year CD at 4%
• $2,000 in 4-year CD at 4.5%
• $2,000 in 5-year CD at 5%
Splitting the money into multiple accounts provides automatic benefits. You have the option to access some of your money earlier (within a year in this example) without incurring penalties for withdrawal before maturation. Plus, you can take advantage of higher rates for longer terms.
Here’s where it gets slightly complicated, but potentially lucrative. At the end of a CD term, consumers are given the option to withdraw their money, renew for another term, or transfer into a new CD. In the example above of a laddered strategy, after the one-year CD matures the consumer can take the funds (which are now enriched with a bit of interest). Or they can reinvest some or all of the funds into a 5-year CD. The saver’s holdings now look like this:
• $2,000 in CD with 1 year remaining, at 3.5%
• $2,000 in CD with 2 years remaining, at 4%
• $2,000 in CD with 3 years remaining, at 4.5%
• $2,000 in CD with 4 years remaining, at 5%
• $2,000 (after keeping the interest earnings from original 1-year CD) in new 5-year CD at 6%
Opening a new 5-year CD means you’ll get the best rate available on the market, better than opening another one-year CD. But at the same time, you’re still only a year away from a matured fund.
This process continues each year, building your total savings by receiving the best interest rate, yet still providing you the liquidity of other savings accounts.
CD laddering strategies can be highly adaptable and personalized to your situation. Whether you use 12 one-month CDs for a year of savings, or stretch the ladder over a longer time period, you’re taking advantage of better rates of return in a protected and safe method.
For Additional Reading:
How to Build a CD Ladder (Infographic):
How to Create the Ultimate CD Ladder: http://www.consumerismcommentary.com/how-to-create-the-ultimate-certificate-of-deposit-cd-ladder/
CD Ladders: A Smart Savings Strategy
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