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.

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.

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