A CD, or certificate of deposit, is one of the simplest, lowest risk types of investment. It’s a contract with your bank for them to pay you X amount of interest on X amount of principal invested over X number of months or years. It’s about as straight forward as an investment gets.

But there are ways to arrange the use of multiple CDs either to increase liquidity or to improve on your rate of return, using a CD ladder strategy. “Ladder” refers to using different CD maturities, and it can be a real advantage.

Why invest in CDs?

CDs are fixed income investments generally purchased through a bank. Not only do they offer a fixed rate of interest on the income side, but they also provide full return of principal at maturity and little if any fluctuation in value beforehand. In addition, in the U.S., CDs are insured by the Federal Deposit Insurance Corporation (FDIC) for up to $250,000 if they’re held in a bank.

This is very different from stocks, mutual funds and even bonds, each of which carry the risk of at least partial loss of the initial investment, particular if sold prior to maturity in the case of bonds. You would invest in CDs then as a way of protecting the value of at least some of your portfolio from price fluctuations.

You can do this with savings accounts and mutual funds as well, but because they are time deposits, CDs pay a higher rate of interest.

In addition to CDs, you can also use government securities to serve the same purpose. In the U.S., Treasury securities can be purchased and held in your bank, in an investment account, or with the Treasury Department itself through Treasury Direct.

What is a CD Ladder?

Since CDs are purchased at fixed rates and for fixed periods of time, you can be locked into a given interest rate until the certificate matures. You can work around this with a CD Ladder.

Essentially what you’re doing with a CD Ladder is assembling a portfolio of CDs with different maturity dates and different interest rates. That means that you’ll have greater liquidity through a sequence of various maturities, as well as the flexible interest rates afforded by multiple CDs.

In a way, you’re creating your own money market fund in which you choose the interest rates and maturity dates of the component investments.

Laddering for maximum liquidity

There are at least two ways you can create a CD ladder, based on your own needs and preferences. The first is laddering for liquidity.

Since CDs have fixed terms and typically include early withdrawal penalties, they’re not quite as liquid as saving accounts and money markets. You can get around that by staggering your maturities.

Let’s say you have $12,000 to invest in CDs; if you put it all into a single CD with a maturity of 12 months, your money will be tied up for a full year before you can withdraw any money penalty free. But if instead you decide to put your money into 12 CDs of $1,000 each, and purchase one each month, after 12 months you’ll always have a CD maturing. You can either take the cash and use it for something else, or roll it over into another 12 month CD.

Another advantage here is interest rates. If you invest in a single CD, you’ll get the rate on that day. But if you invest monthly, you’ll get an average rate for the whole year, which can be higher or lower, but at a minimum, it will keep your options open.

Laddering for maximum return

This involves investing in a portfolio of CDs with different maturities. You could invest equal parts of your CD money in certificates maturing in one year, two years, three years, four years and five years. The overall rate on your CD portfolio would then be an average of the different CD maturities.

Since interest rates on CDs tend to be higher on longer term certificates, your total return will be greater than it would be with a portfolio of only one year CDs invested on different dates. In this way you’re maximizing your return in any given year.

When to ladder for liquidity and when to ladder for return

Each type of laddering structure can work best under different circumstances. If you anticipate that rates are or will be rising in the future, you’ll probably better off with a portfolio of one year CDs. Because the maturities are shorter and one is coming up each month, you’ll be able to take advantage of the new, higher rates much faster than you would with a portfolio of CDs with longer maturities. The liquidity is just greater with shorter term certificates.

If on the other hand you believe rates will be falling in the future, you’re better off laddering for maximum return with the longer term maturities. A CD portfolio with two, three, four and five year maturities will have your rates of return locked in while shorter term rates fall.

If you have CDs do you use a ladder system of any kind either to increase liquidity or return?

Kevin Mercadante
Kevin Mercadante

Kevin Mercadante is professional personal finance blogger, and the owner of his own personal finance blog, OutOfYourRut.com. He has backgrounds in both accounting and the mortgage industry. He lives in Atlanta with his wife and two teenage kids and can be followed on Twitter at @OutOfYourRut.