Setting Up a CD Ladder: The Pros, Cons and How-To

by Andrea Norris-McKnight

Setting Up a CD Ladder photo

Are you considering setting up a CD ladder? Here are the pros and cons to consider and the steps to take.

A Certificate of Deposit (CD) is a financial product offered by banks and credit unions that allows individuals to deposit money for a fixed period of time, typically ranging from a few months to several years, in exchange for earning interest. Financial experts agree that CDs are a safe investment with relatively low risks, although, like any investment, they have pros and cons.

A CD ladder is an investment strategy for investing in multiple CDs with varying maturity dates. It provides a balance between the liquidity of short-term CDs and the higher interest rates of long-term CDs.

Read on for the advantages and disadvantages of this investment strategy and a step-by-step guide on setting up a CD ladder if you decide this is a wise option for your finances.

How a CD Works

When you open a CD, you agree to deposit a certain amount of money, known as the principal, for a specified term. In return, the financial institution pays you a predetermined interest rate. The interest rate typically depends on the term length and prevailing market rates, with longer-term CDs generally offering higher interest rates.

Once the term of the CD ends, also known as the maturity date, you can withdraw your initial deposit along with the accrued interest. However, if you need to access your funds before the maturity date, you may incur an early withdrawal penalty, which can reduce your overall earnings.

CDs are popular for individuals seeking a low-risk investment option that provides a predictable return and those looking to diversify their investment portfolio.

The Pros and Cons of Investing in CDs

As with any investment strategy, there are pros and cons to consider carefully before setting up a CD Ladder.

Pros

  • Regular income: A CD ladder provides a steady income stream as each CD in the ladder matures.
  • Reduced interest rate risk: You can reduce your exposure to interest rate fluctuations by staggering the maturity dates with a CD ladder. As interest rates rise, maturing CDs can be reinvested at higher rates, while longer-term CDs continue to earn interest at the original rate.
  • Liquidity: With a CD ladder, a portion of the investment matures at regular intervals, providing liquidity and accessibility to funds when needed.
  • Safety: CDs are typically issued by FDIC-insured banks or NCUA-insured credit unions, making them a safe and secure investment option with little to no risk of losing principal.
  • Flexibility: A CD ladder allows you to adjust the ladder’s structure over time, depending on your changing financial needs and interest rate outlook.
  • Low minimum investment: CDs often require a lower minimum investment than other investment options.
  • No fees or commissions: Most CDs do not have fees or commissions, so your interest earned is generally not reduced by additional costs.

Cons

  • Lower returns: CDs generally offer lower returns than other investment options such as stocks, bonds or mutual funds, which may not be suitable if you seek higher investment returns or growth.
  • Inflation risk: The interest earned on CDs might not keep up with inflation, potentially eroding the purchasing power of your invested principal over time.
  • Opportunity cost: By allocating funds to a CD ladder, investors may miss out on potentially higher returns from other investments.
  • Early withdrawal penalties: If you withdraw funds from a CD before maturity, you may pay a penalty that could negate any interest earned and even reduce the initial principal.
  • Interest rate risk: If interest rates rise during the term of your CD, you may be locked in at a lower rate and miss out on the chance to earn higher returns.

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How To Set Up a CD Ladder

You should know a few terms to make it easier to understand the concept of a CD ladder.

The “ladder length” is how long it will take for all CDs in your initial ladder to mature. If you have five CDs in your ladder and the longest term is five years, your ladder length is five years.

The ladder “rungs” refer to the individual CDs. If you set up your ladder using five CDs, your CD ladder has five rungs.

You can set up your CD ladder as follows:

1. Determine your investment amount.

Decide how much money you want to invest in your CD ladder. Remember that you cannot access this money without incurring a penalty until your CDs mature, so carefully consider how much you can afford to invest or if a high-yield savings account might be a better option for you.

2. Choose the ladder’s length.

Most CD ladders are typically one to five years or more. Base the ladder length of your savings goal. If you’re tucking the money away to buy a new car in a few years, you want a two-year ladder length. If your savings goal is to add a liquid investment to your portfolio, then a ladder length of five years or longer will probably serve you best.

3. Divide your investment among the rungs.

Divide your total investment amount into equal portions that will create the rungs of your ladder. For example, if you’re setting up a five-year ladder with $10,000, you might divide it into five $2,000 portions.

4. Open the CDs.

Open a CD for each investment portion, with maturity dates spaced out evenly. For a five-year ladder, you might open CDs with maturity dates of one, two, three, four and five years from now. Carefully compare interest rates offered by several banks before simply opening CDs with your current bank. Online banks often have some of the highest CD APYs.

5. Reinvest matured CDs.

As each CD matures, reinvest the principal (and interest, if desired) into a new CD with the same maturity term as the longest CD in your ladder. With a five-year ladder, you’d reinvest the matured CD into a new five-year CD.

6. Maintain and adjust your ladder.

Monitor your CD ladder and adjust it to meet any changing financial needs and goals. If interest rates change or you need more liquidity (access to your money), you can adjust the ladder’s length or change the intervals between the rungs.

Takeaway

CDs are a suitable option if you’re seeking predictable investment returns and safety. The trade-off for the safety CDs afford is often lower returns and limited liquidity. Evaluating your financial goals and risk tolerance before deciding whether a CD ladder is a wise investment choice is essential.

Also, before opening any CDs, compare APYs and early withdrawal penalties since they can vary significantly between financial institutions. You may find better rates through online banks rather than your local traditional bank.

Reviewed January 2024

About the Author

Andrea Norris-McKnight took over as the editor of The Dollar Stretcher and After 50 Finances after working under the site founder and previous editor for almost 15 years. She has also written for Money.com, GOBankingRates.com, HavenLife.com and The Sacramento Bee.

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