The certificate ladder is a strategy to distribute a savings amount across several certificates of deposit with different terms. It provides the opportunity to earn higher interest rates without the risks that come with keeping the entire amount in a single account.
Definition and Examples of a Certificate Ladder
When using a certificate ladder, you divide your money among several certificates of deposit, each with a different term length. The idea is that each account matures after a different number of months or years.
This strategy allows you to benefit from the best annual percentage yield you can get with a long-term certificate of deposit while enjoying peace of mind with short-term certificates of deposit. You gain the flexibility to reinvest the principal and interest at the end of each certificate’s term or simply withdraw the cash.
Each certificate you open represents a step on the ladder, each with a different term length. For example, a five-step certificate ladder is a common option. The five-step ladder includes five certificates of deposit with maturity dates of one year, two years, three years, four years, and five years. You can also use four-step ladders, which include short-term certificates of deposit with maturity dates ranging from three months to over a year. Often, you will invest the same amount in each account, but this is not a requirement.
Note: Ladders that contain certificates with a term of one year or less are also referred to as mini certificate ladders.
How Does a Certificate Ladder Work?
Certificate accounts are appealing to use with the ladder strategy because you can secure a higher competitive interest rate than a regular savings account. Certificates can provide more predictable returns than other accounts. For instance, you would open a certificate of deposit account, then choose a specific term length—one year, three years, or five years—and deposit a large sum at once. Often, your financial institution pays a fixed interest rate, so you don’t have to worry about market fluctuations. However, you can choose variable rate certificates if you accept the risk that your annual percentage yield may increase or decrease.
When planning your certificate ladder, you can choose from various types of certificates to suit your needs. For example, you might select a traditional or jumbo fixed-rate certificate for maximum predictability. Alternatively, you may incorporate a variable rate certificate that responds to market changes, or opt for a liquid certificate to avoid penalties for early withdrawal. Remember that your interest rate can vary depending on the certificates you use in your ladder, along with the terms you select.
Your financial institution may have standard certificate ladders that you can easily enroll in; however, you may also develop a custom strategy that could be more complex and even involve working with multiple banks to take advantage of attractive interest rates. In any case, you will need to complete an application to open a specific number of certificates you desire, funding each with your savings amount.
Note: Banks often have minimum deposit amounts that can vary based on the type and term of the certificate, and this can impact your certificate ladder strategy. For instance, obtaining a jumbo certificate with an attractive interest rate may require a minimum investment of $100,000.
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You have control over what you do with the funds of each certificate during the grace period at the end of the maturity. Typically, your bank may have an automatic renewal option so that the maturing certificate is automatically renewed at the longest duration you’ve used and at the current available interest rate. Thus, you might convert a one-year certificate that matures into a five-year certificate. However, you can also withdraw the funds from that maturing certificate and use them as you wish. For example, you might find that another bank offers better rates and decide to withdraw the funds and invest them in a certificate there at maturity.
To get a better idea of implementing a certificate laddering strategy in practice, assume you have $20,000 and want to build a five-step certificate ladder. You might do the following:
You ask your financial institution to open five high-yield certificates of deposit, each worth $4,000, with maturity dates of one year, two years, three years, four years, and five years. Interest rates are tiered, so you typically earn more the longer the term. For instance, your interest rates for the annual terms might be 0.55%, 0.60%, 0.65%, 0.75%, and 0.80% respectively. When the first certificate reaches maturity, you convert it into a five-year certificate to continue building your ladder. You will benefit from earning a competitive annual percentage yield on the original deposit plus the interest accrued during the first year. Since the other certificates continue to earn interest as well, and at higher rates, you would be better off than putting all the money in the one-year certificate earning 0.55%. You will continue to decide what to do with the funds.
Source: https://www.thebalancemoney.com/what-is-a-cd-ladder-5218856
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