With interest rates at all-time lows, people looking to invest cash in CDs face tough decisions about how long they should lock up their money. Should they invest in a short-term CD that earns only a little bit more than a regular savings account? Or should they lock up their money in a longer-term CD that earns more, but risk that rates will skyrocket shortly and they’ll be stuck in a relatively low-interest CD?
Although many economists and journalists will make forecasts about when rates will go up, academic studies show that the market is very bad at predicting interest rates beyond a few months. So even as an informed saver, it’s very difficult to make a bet as to whether it’s better to get short or long-term CDs in this environment.
Perhaps the best hedge between these two options is to ladder CDs. In a CD ladder, the saver evenly divides their money among short, medium, and longer-term CDs, thus allowing them to have some of their money locked up at a higher interest rate, but keeping other money in short-term CDs so it’s available if rates rise.
Laddering CDs can create additional work, but is fairly simple to do. Let’s say a person has $10,000 to invest. He or she can divide that amount into 5 equal parts, in this case $2,000 each, and then invest each division into a 1,2,3,4, and 5 year CD. Then, each year when a CD comes due, the saver can renew it for a 5-year CD to recreate the original ladder. And since the saver is now only buying 5-year CDs, they’re now always locking in the best rate at the time.
Such CD ladders are best for savers who have an indefinite time frame for needing their money – they ultimately get to lock in the highest rates since they’re buying 5-year CDs, but in any given year, 20% of their money is available for them to withdraw with no penalty if they need it. Plus, each year 20% of their money is being renewed at the highest interest rate at the time, meaning they don’t end up having all of their savings locked in to a particularly low rate for five years if interest rates skyrocket.
Depending on the saver’s preferences, the overall time period can be shorter or longer than 5 years (e.g. 3 – 10 years). And the saver can also divide up their money to a finer degree, investing in CDs that come due every 3 months, or 6 months, instead of every year. Of course, buying more CDs creates more work, and requires more money to meet CD minimums. However, the more finely the money is divided, the more options the saver will have to divide their cash among various banks and optimize for the best CD rates.
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