3 ways to ladder CDs for highest interest rates

One of the hardest part about investing is trying to figure out your risk and your potential return. That's what makes certificates of deposit very alluring for safety-oriented investors. It's simple. Your principal is backed by FDIC insurance as long as you stay under the deposit insurance limit. And your return is quite simply your best CD rate plus any compounding effect.

But your still have risk when investing in CDs. You run the risk that inflation will outpace your earnings. You also have the opportunity risk of picking the wrong maturity dates if interest rates increase or decrease during the lifetime of your CD. That's why laddering your CDs to have them mature in different time frames is a good idea. It helps reduce risk and maximize your return.

Here are three different ways you can ladder your CDs:

  1. The straight ladder

    The straight ladder is pretty simple. You set up your CDs to mature at staggered times like every six months, year or two years. This way you are in a good position to take advantage of higher interest rates as your CDs mature and you should earn more money than if you kept all your money in short term CDs or savings accounts.

    An important part of laddering CDs is to search for the best CD rates as your CDs mature. In some cases when your CD matures the original bank will match another bank's rates, but usually you will have to switch to a new bank to take advantage of a better rate. Fortunately, if you use online banking this is very easy. GoTalkMoney has a list of the best CD rates for terms ranging from one month to ten years that can help you when your laddered CDs mature.

  2. The barbell CD ladder

    An alternative to spreading out your CD maturities in a straight ladder is using what is referred to as a barbell ladder. With this strategy you invest half of your money in long-term CDs. The other  half is kept in short-term CDs, say terms of one year or under. This approach gives you protection against the risk of rates staying low or suddenly moving higher. Your long-term CDs with higher rates will help you if interest rates stay low. Your short-term CDs stand ready to take advantage of bank rate specials as they mature. If the yield curve has an anomaly or spike, you can strategically place your barbells where the rates look the best.

    A hybrid barbell ladder is a strategy where you place half your funds in long term CDs and the other half in bank money market accounts to wait out better rates. The hybrid ladder is attractive if the best money market rates are as good as short term CD rates.

  3. The easy penalty ladder

    A unique strategy to take advantage of the potential for rising rates involves investing with banks that offer generous early withdrawal penalties. With this strategy you pick banks with a better early withdrawal penalty than the standard 180 days of interest. You pick this CD even if the rate is slightly lower than the best CD rates. Your aim is to beat the rates offered on savings accounts, money market accounts and checking account, but leave yourself a big option if rate increase much higher.

    Here is an example. Say you buy a $25,000 5-year CD at 3 percent, but after a year CD rates have moved up quite a bit. The new rate on a 4-year CD is now 4.25 percent. You decide to break the CD at the bank and pay the 90-day interest penalty which is roughly $185. After you reinvest your principal for four years at the new bank, you earn an extra $1,240 in interest by the time the CD matures. Even after subtracting out the penalty, you are left with a tidy profit. Imagine using that strategy with several CDs and you can see the advantage.

    This strategy can have a big payoff, but there are a few points to consider. You have to very diligent to watch rates and run your numbers accurately to determine when to act. Of course, you also need CD rates to move quite a bit higher for the strategy to pay off.

    Finally, if you dig down deep in the CD disclosures, most banks state that they are not required to honor the stated early withdrawal penalty. Most do, but you never know for sure, so plan your risk-taking accordingly.

Bank account changes may not pay

Keeping money outside of a bank is becoming more popular. The FDIC conducted a survey of American households that indicated that close to 30 million households are now using alternatives to banks. Money orders, checking cashing services and payday loans are just a few of the costly options households are utilizing.

The FDIC plans to address the large number of un-banked and under-banked households in 2011, but meanwhile even more alternatives to traditional banking are tempting savers. These new options may sound exciting, but they have their pitfalls.

Peer to peer lending

Social lending, also called P2P lending, refers to the platform where lenders and borrowers can formalize loans online. By taking out the middle man, borrowers can find good rates on their small personal loans. Sites likes Prosper, Lending Club and Loanio have processed millions of dollars in loans that have been funded by investors willing to give the online marketplace a try.

It sounds like a good idea with potential winners on both sides, but the problem arises when the lines between investing safely and lending with risk are blurred. Many of the social lending sites offer direct comparisons of their average lender returns to the rates paid by banks on CDs, money market accounts, savings accounts and checking accounts. This is misleading because returns for P2P lending can be wildly variable and are not guaranteed, while investing in a bank deposit product offers FDIC insurance protection.

Social lending sites have now captured the attention of regulators. State securities authorities and the National American Securities Administration Association Inc. have issued warnings to advisers and investors about the costly risks of  peer-to-peer lending on the internet for both borrowers and lenders.

Preloaded cards

Prepaid cards give consumers the ability to load a card with real value (cash) and avoid the pitfalls of overspending or paying the high interest rates and fees associated with credit cards. A preloaded card can also help you stay within your budget or might make an appropriate gift for a college student or recent graduate. The cards have become very popular. A Mercator Advisory Group report found that $36.6 billion in funds were pre-loaded  on cards last year. Their research concludes that number will grow to  $118.5 billion in 2012.

Despite the impressive growth, prepaid cards don't make sense for everyone. The biggest objection to the cards to date has been the high fees charged for normal usage. The popular Green Dot card for instance charges $4.95 for initial purchase and $5.95 a month for any month cardholders do not load $1,000 to their card or make 30 purchases. Another card was pulled before ever hitting the market. The Kim Kardashain Kard was proposing fees as high as $60 to $100 just to activate, according to Business Insider.

Savers lose out on earning interest if they use a prepaid card instead of keeping money in a bank. If you can trust yourself not to overspend, your money is much better off in an interest-bearing account.

Money market mutual funds

A very safe place to park cash has always been the safe mutual fund money markets offered by fund companies like Fidelity, Vanguard and Dreyfus. Money market funds as they are called, can almost act as a replacement for a bank account by offering investors check writing privileges and the ability to transfer funds online. However, there are some important differences that make mutual fund money market an inadequate replacement for a checking account or money market account at a bank.

The most obvious difference is that the highest bank money market accounts offer rates over ten times more than the paltry yields earned right now on money funds. Investors can lose out on significant investment income by parking money in money funds, instead of bank accounts.

A second difference is fees. Bank account fees are pretty simple. Usually you can even avoid paying any monthly fees. Money funds are a different story. The fees and the expense associated with running your fund are deducted automatically from the performance return of the fund. The fees are usually small, but you are still paying extra money for keeping money outside of a bank.


Disclaimer:This content is not provided or commissioned by American Express. Opinions expressed here are author's alone, not those of American Express, and have not been reviewed, approved or otherwise endorsed by American Express. This site may be compensated through American Express Affiliate Program.

Bank Name: Your E-mail: Description (Please include URL):
We HATE spam as much as you, we don't sell your e-mail address!