Certificates of Deposit are not for everyone but if you live long enough you will probably be considering them at some point. If you are going to invest with what banks currently call CDs then you should be smart about it. Using a technique called "laddering" or "stepping" you can improve your liquidity and maximize your returns over the long run by protecting yourself from downturns in market interest rates.
A quick scan of any banks listings of CD rates (see chart below) reveals nothing spectacular in their scheme unless you look at the details of the differences between time periods. Historically banks have tried to give you a little bump at the 6 month mark and there are good reasons for this. Banks are fairly certain of what the economy is going to do over the next 6 months but, obviously, risk changes in relation to time. The problem for us is that we want the higher returns of the longer investments, we like the safety of CDs and we don’t want to be tied down to a low interest rate if things start going up. We also would like to be tied to a high interest rate if things go down. Liquidity would also be a plus.
|Source: Online. Week of 7/3/2006|
Can we get all this? Sure, but like most things in life it involves compromise but compromise is not all that bad. What you need to do is use the “Ladder” or “Step” approach when buying CDs. I’ll explain in an example.
Let’s say you have $12,000 and you want to put it up in a CD because you like the safety. You don’t like the lack of liquidity but you are willing to compromise. So do you put it into a 1 year CD and roll it forever or a 5 year and not worry about it? 5 year CDs will pay more but what if the interest goes up by ¼% to ½% every year for the next several years? You really missed the boat on that one if you went 5 years. Maybe you’ll elect to put your money in 1 year CDs for the next 5 years-great, what if the points drop by the same rate instead of rising? You will be really hurting.
Now consider this; you put $2000 in a 1 year, 2 year, 3 year and 4 year CD and the remaining $4000 in a 5 years certificate. On maturity you would roll each CD into another 5 year CD. Your current rate of return would be about 5.41%, slightly better then if you had placed it all in a 4 year CD.
The benefit now is that you are also protected regardless of how the market reacts. If in the first year the market goes up across the board by ¼% your rate of return would now be almost 5.52% and if this trend continues then your return will move positively with the market.
In a down trend, if we drop by the same rate, you are still getting a 5.43% return so your money actually moved up in this case. Remember, every time a CD matures you are rolling into the longest time period, in this case 5 years.
Eventually, you will have $12,000 invested into five, 5 year CDs, each with a maturity date one year apart. You are getting the highest return possible and are still somewhat liquid.
The step program is a good compromise. It can be used over just about any length of time and is something I always do unless I know for certain that I’m only keeping the money for a fixed period and then moving it out.
One of the best places to use this is with our “3 to 6 months of salary for emergency fund”. Consider this; even if you lost your job you are only going to need 1 month worth of money at a time. I moved out of a money market into six, 6 month CDs each equaling about a months salary and ended up with a better return. Obviously I had to do some work to space them out correctly but I am very happy with the system.