Wednesday, February 10, 2016

Are CD Ladders Worth It These Days?

After more than a year of slowly building it up, I'm approaching the point where I will have reached my goal of saving $10,000 in an emergency fund. The question I now need to address is where should I keep that money. Because it is an emergency fund, it should be in a risk-free, non-volatile investment. That rules out stocks and mutual funds. It also needs to be readily accessible. Finally, I'd like it to earn as much interest as possible under these constraints.

CD Ladders

The requirements that the emergency fund be readily accessible and safe means the options are limited to a product from a bank or credit union - something FDIC insured and that won't lose value. Typically, the choices come down to either a savings account or certificates of deposit (CDs). In normal economic environments, CDs have higher rates than savings accounts because your funds are locked up for a period of time. CDs typically have a penalty for early withdrawal, usually an amount equal to the interest you would have been paid for some amount of time. But because interest rates change, you don't really want to be locked into a low interest rate for an extended period of time. If rates go up, you want to be able to move your money into a CD that pays the higher rate. So the concept of a CD ladder was invented. A CD ladder gives you two benefits: frequent availability of your funds and typically higher interest income than can be found in a savings account.

How They Work

A CD ladder is actually a series of individual CDs created initially with differing maturity dates. Each CD is a rung of the ladder. The availability of your funds is determined by the length of time between your rungs. Let's call this an interval. As each rung comes to maturity, you renew it for the length of your biggest rung. As time passes, you'll end up with several CDs, each maturing every interval. The below image shows a three rung ladder with an interval of one year. (Click image to enlarge.)

Let's look at how I want to build my ladder. I have $10,000. I want the intervals of my rungs to be three months, meaning every three months, I want one of my CDs to be maturing. To put it another way, I want a portion of my emergency fund cash available to me every three months. The maximum length of my ladder will be 1 year. Thus, my ladder will have four rungs, each coming due every three months.

To create this ladder, I have to open four certificates of deposit containing $2,500 each. The first will mature in three months, the second in six months, the third in nine months, and the last in one year. After three months pass, I'll roll my maturing three month CD into a new 1 year CD. Similarly, three months later, I'll roll my now maturing six month CD into a new 1 year CD, and so on. After one year, I'll have 4 CDs, each with a 1 year term, with one coming due every three months. Because longer term CDs pay higher interest rates, this process lets you earn the higher interest rate while keeping a portion of your funds more liquid than they would be if they were all in a single long term CD.


There are a couple downsides to this. The biggest is that it is up to you to manage your rungs for the first year (or however long your ladder is), while the ladder is building out. Unless your bank hears differently, when your CD matures, they will just roll it over into a new CD of the same term. Once your ladder has been populated with the longest term CDs, this is what you want, but for that initial year or so, it will be up to you to roll the short term CDs into the longer terms CDs as they mature.

Another drawback is not all of your funds are constantly available. For example, in the above situation, if I have an emergency and need $5,000 immediately instead of just $2,500, I would have to liquidate two rungs of the ladder and possibly face early withdrawal penalties.

Early withdrawal penalties vary, depending on the financial institution and the length of the CD. In some cases, you may just lose all accrued interest to date. In others, you might be charged a penalty of x days interest. If you have not accrued that much interest at the time of your withdrawal, the financial institution will take that fee out of your principle.

These Are Strange Times

In the current historically-anomalous ultra-low interest rate environment, the CD ladder also has a surprising drawback: it may not be worth it. As I started looking into setting up my own CD ladder, I quickly discovered something. Take a look at these rates from Ally Bank (screenshots taken on Dec 23, 2015, when I am writing this):

Notice anything? The interest rate on a plain savings account is higher than the 3, 6, and 9 month CD rates! And it's only 0.05% less than the 1 year CD rate. So right now, it doesn't make sense to build a CD ladder of 1 year in length. You'd earn more interest just keeping your funds in a plain old savings account for the first year and after that, you'd only be losing out on 0.05% interest.That's worth the convenience of having all your funds fully available without any early termination fees.

If you have more funds available or are willing to accept longer time frames for your CDs,  a CD ladder might still be worth it. Try looking at 5 year CDs. As of this writing, Ally Bank offers a 5 year CD at 2% interest.

As the Fed starts raising rates, this situation will probably reverse, so keep your eyes open and be ready to build your ladder when the interest rate environment returns to normal.


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