Start Saving Using a CD Ladder

Certificates of deposit (CDs) typically outperform bank savings accounts [1] and in the U.S. are guaranteed by the FDIC (or the NCUSIF for credit unions) for up to $250,000. A CD ladder -- a series of CDs with staggered maturity dates [2] -- provides both liquidity and respectable returns. If you have anywhere from $1,000 to $50,000 siting in savings, this might be a good core-investment option for you!

Steps

  1. Have an emergency fund in a bank account or money market fund so that you are well prepared. You'll need three month's worth of expenses in a liquid account in a bank or money market fund where you can immediately withdraw the money in case of urgent and unexpected expenses. You will pay for that liquidity, however, because such accounts offer very little interest. Just the same, bank or money-market accounts are useful for paying immediate expenses and for building up funds to put into CDs and other investments.
  2. Understand CD basics. CDs are fixed-income investments for a predetermined length of time (the "term"). [3]. They are illiquid: you cannot normally withdraw your money during the term of a CD unless you're willing to pay a penalty fee. CDs may be purchased from banks, credit unions, or brokerages. The interest earned may be added to the CD itself or be rolled into another account. Terms will range from one month to five years. Generally, the longer the term of a CD, the larger the minimum investment required and the higher the interest rate you'll earn. In addition, there are a variety of options available. [4] you need to be aware of when evaluating CDs.
  3. Set your goal, and design your CD ladder. What are you saving for? Purchasing a car, a home, college or retirement? Your goal determines how much you need and when you need it.
    • To create a more substantial emergency fund (three to six months worth of expenses is often recommended) you might need $3,000 a month for six months or $18,000. Each time a CD matures, roll it over into a new six-month CD.
    • If you're saving for a new car or down payment for a house, invest in longer CDs and purchase progressively shorter ones so that all your investments mature at the time you need the money. For instance, if in five years you would like to purchase a home you can buy a five-year CD now, then in one year purchase a four-year CD, in another year purchase a three-year CD, and so on. All the CDs will mature at the time you plan to need the money. That's the "ladder."
    • For retirement you might have CDs with five-year maturities staggered a year apart, each to be reinvested in new CDs.
  4. Shop for the best buy. There can be a wide range of rates paid by CDs with the same term. Use a calculator to show you the best rates available. Consider all your options when shopping.
  5. Review CD features, and ask questions if you don't fully understand them.
  6. Rollover maturing CDs. Before a CD matures, shop around for reinvestment options. If you don't take immediate action, the CD may automatically roll over and may not earn the best interest rate available. Most banks will require you to transfer your investment into a checking or savings account within ten days of maturity. Otherwise it will automatically roll over into a new CD with the current interest rate. This is great if you don't want to have to actively manage your money, because the new investment will have the same term as your old one. Your income from the previous CD will be added to the balance, and you will earn compounded interest on those earnings.

Tips

  • Read the fine print. All of it. Ask questions about what you don't understand.
  • Credit unions generally provide higher interest rates than commercial banks do. Many credit unions make it easy to open an account and may no longer require new customers to be affiliated with their sponsoring organizations.
  • The key to using a CD ladder is to tailor it to your own personal needs. No one understands your financial situation better than you do. If you start saving and find that you can get by without that money more easily than you thought, try longer terms, which typically pay higher interest rates.
  • Since CDs have guaranteed interest rates, there is no risk of losing money as there is in the stock market.
  • Federally chartered banks and credit unions (and any CDs purchased there) are typically insured by a governmental agency such as the FDIC or the NCUA. That makes CDs from banks and credit unions among the safest investments available. CDs from brokerages are only as safe as the brokerage.
  • Keep track of your interest! When tax time comes it must be reported to the government as "interest income". While early on, you may be able to deduct all of your interest income, eventually you will be making enough money to pay taxes, and no one wants to have the IRS coming after them.
  • To minimize your paperwork, add to the CDs you currently have maturing instead of starting new ones. Try to limit your ladder to 5 or 6 CDs with one maturing every year, every six months or every month.
  • Laddering also achieves dollar-cost-averaging,earning a more reliable return than when investing all your money at once [5]

Warnings

  • CDs are subject to interest rate and inflation risk[1] - you're locked into the investment even though interest rates (and inflation) have risen.
  • The $250,000 insurance on CDs is currently available in the US only through the end of 2013, after which it is scheduled to revert to $100,000. However, you can effectively increase the insurance amount by obtaining CDs at multiple institutions and by different combinations of ownership with your spouse.
  • Early withdrawal penalties are very expensive. If you don't absolutely have to have that money now it would be better to wait. If you have never invested before, err on the side of shorter maturities.
  • If you have a complaint about your purchase of a CD, follow the FDIC recommended procedure to resolve it.
  • Longer terms do not always guarantee higher interest rates. There is a yield curve[6] which shows interest rates for different terms (one month to five years). An inverted yield curve indicates a lower interest rate for longer terms.

Related Articles

Sources and Citations

  1. ↑ 1.0 1.1 http://www.kiplinger.com/basics/archives/2003/04/savings2.html
  2. ↑ http://www.kiplinger.com/basics/archives/2003/04/savings3.html
  3. ↑ http://www.bankrate.com/brm/green/investing/investing2-1a.asp?caret=7
  4. ↑ http://www.bankrate.com/brm/green/investing/investing2-2a.asp?caret=8
  5. ↑ http://www.bankrate.com/brm/news/sav/20010521b.asp
  6. ↑ http://www.smartmoney.com/investing/bonds/the-living-yield-curve-7923/

You may like

Retrieved from "https://kipkis.com/index.php?title=Start_Saving_Using_a_CD_Ladder&oldid=268316"