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CD Laddering Strategy
 
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What is a CD
Certificate of Deposits or CD's are bank accounts that earn interest on the principal you place with a bank.  It is much like a loan, except you are loaning the money to the bank and they pay you interest.  The CD usually has a term anywhere from a 1 month to 5 or more years in which you agree to give the bank your money for this period in return for interest paid back to you on that money.  If you withdraw the money before the term expires (that is, before the CD matures) there is usually a penalty equivalent to the loss of several months interest.  Many CD's offered by banks are FDIC insured, which means that the Federal Government will replace your principal up to a certain amount if the bank goes out of business.  Go to the FDIC web site to check on the financial health of a bank you are considering investing in or go to BAUERFINANCIAL.COM to see a rating of a bank using a 1 to 5 star rating system.

CD's are good investment vehicles that give you a fixed income and are low risk.  To maximize the return on your money, use a strategy called Laddering.  Laddering a CD portfolio is a lot like dollar-cost averaging when you buy stocks. You don't invest all your CD money at one low rate of return. You are also never more than a year away from at least some of your money. Go to the Bank of America web site, select your state, and click on "CDs" to use their really cool CD Laddering Calculator.

Here's how laddering CDs works
You go to the bank with $25,000 and buy a $5,000 one-year CD, a $5,000 two-year CD and so on until your last $5,000 buys you a five-year CD.  Each year is a rung on the ladder.  When the one-year CD matures, you reinvest that money in a five-year CD because by that time your five-year CD has four years left until it matures.  As each year's CD comes due, you roll it into a five-year CD.
 
Here is an example I found on the Internet of how laddering a CD is better that putting all of your money in at one particular maturity:

The laddered CD program helps give you more liquidity while offering a more stable source of income.  Consider what would have happened to two hypothetical investors who invested $50,000 in 1998.

Investor A bought a $50,000 one-year CD in 1998 and reinvested in one-year CDs every year thereafter at the following rates:
 
Investor A -- Reinvesting plan
Year
Rate 
May 1998
5.85%
May 1999
6.10%
May 2000
5.60%
May 2001
5.05%
May 2002
6.50%
May 2003
4.00%
 
 
Investor B bought $10,000 each of a one-, two-, three-, four- and five-year CD in May 1998 and then bought $10,000 each of a five-year CD as each CD matured. The CD rates were as follows:
 
Investor B -- Laddered portfolio
Initial Investment 
Buy when initial CD matures
May 1998 1 year @ 5.85% May 1999 5 years @ 7.10%
  2 years @ 6.40% May 2000 5 years @ 6.20%
3 years @ 6.70% May 2001 5 years @ 5.95%
4 years @ 6.90% May 2002 5 years @ 7.20%
5 years @ 7.10% May 2003 5 years @ 5.45%
 
 
Let's compare the annual income stream generated from these two strategies.
 
Income comparison:
Reinvesting vs. laddered portfolio
Year 1
Year 2
Year 3
Year 4
Year 5
This year
Total income
Investor A
$2,925 $3,050 $2,800 $2,525  $3,250 $2,000 $16,550
Investor B 
$3,295 $3,420 $3,400  $3,190  $3,325  $3,355 $19,985
 

The laddered-CD plan (Investor B) returned $3,435 more interest income during the six-year period, including this year.  The plan also provided a steadier stream of income.  Investor A's income fluctuated as much as $1,250 between the best and worst years, whereas Investor B's income only fluctuated as much as $230.  In a normal yield curve, longer-term maturities will typically have higher yields than shorter-term maturities.
 


Links
To Learn more about CD-Laddering and chosing a good bank, visit these links:

 
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Last updated: 6/24/02