Party Like It’s 1999, CD Ladders are Back!

CDs, or Certificates of Deposit, have not been a highly regarded savings vehicle for nearly 20 years because the rates on these instruments have been so poor. Up until recently, they offered very little to no additional return compared to high-yield savings accounts, while simultaneously locking your money in for an extended period of time. Even when a CD did eke out an extra 0.25% of yield, the juice simply was not worth the squeeze.

However, in the last few months, CDs have been yielding considerably more than high-yield savings accounts, while offering many of the same benefits found in high-yield savings. With the spread between high yield savings and CDs increasing to 1% or more, these have become more favorable vehicles to safely earn on money deposited without subjecting it to the risks of the market. This article discusses how CDs work, the benefits and drawbacks of CDs, as well as how to think about the implementation of CDs in your overall savings strategy.

How CDs Work

When you deposit money into a CD, you are agreeing with the bank that you will deposit your money at their institution and promise to maintain that deposit for an agreed upon period of time. CDs are typically at least a six-month commitment (although 3-month CDs do exist), but can range to as high as a 10-year duration. As long as your money stays deposited for the length of time agreed upon, you will earn the interest rate agreed to. However, should you decide to withdraw your money early, the institution will penalize you by not paying a certain amount of interest, depending on the length of the CD. Your initial deposit will never lose money, even if you need to withdraw early. When the CD “matures,” meaning that the term has ended, the CD will typically renew automatically unless you tell the bank to do something else with the funds.

The Benefits of CDs

First, CDs are FDIC-insured up to $250,000 for individuals or $500,000 for married couples. For most households, this will more than cover whatever amount is allocated in these instruments. Second, they are not subject to market risk, so unlike money market funds or bond funds, the return you agree to is guaranteed by the bank. The yields on shorter term CDs tend to be higher than what is offered in high-yield savings, but just like high-yield savings you have access to those funds within a couple of business days should you need it. 

The Drawbacks of CDs

CDs will penalize you with respect to your earned interest if you do need to withdraw the funds early. Additionally, if interest rates rise, your CD may not adjust accordingly until after it matures, meaning that your CD could be outperformed by high-yield savings if rates move up relatively rapidly, particularly with longer duration CDs. Finally, the interest earned in CDs is subject to income tax; this is no different from earning interest in high-yield savings.

Building the CD Ladder

One of the key challenges with CDs is that because your interest rate is locked in for a period of time, if interest rates rise the yield you are earning may underperform a high-yield savings account, particularly if interest rates rise rapidly in a relatively short period of time. One way to combat this is to build what is called a CD ladder. In a CD ladder, you are going to purchase CDs periodically – we tend to see purchases made quarterly. This helps avoid timing the market poorly by having all of your CDs locked into a single rate, and it gives you the flexibility every few months to decide whether it is worth continuing to hold your money in CDs or to return your funds to high-yield savings if the new CD issues aren’t offering a strong enough return.

Scenario Time!

For example, let’s pretend that you have $10,000 that you intend to purchase CDs with and the current interest rate is 5.25% APY for a one-year CD. You decide to spend all $10,000 at once and lock in that rate. You will earn $525 in interest, but you will have to wait a full year for your money to become available again to make another choice with.

Scenario #1: Suppose inflation ends up being stubborn and the Federal Reserve decides two months into the year to raise interest rates by 0.25%. Three months later, they raise rates again by 0.25%, and a couple months after that they raise rates one more time by 0.25%. Each time they raise, about a month later both the CD and savings account rates rise by the same amount. By using a CD ladder, you would capture the following:

First deposit: $2,500 at 5.25%
Second deposit: $2,500 at 5.50%
Third deposit: $2,500 at 5.75%
Fourth deposit: $2,500 at 6.00%
Average yield: 5.625%

This average yield is considerably better than the 5.25% we were originally offered at the beginning of the year.

Scenario #2: Suppose inflation ends up being stubborn and the Federal Reserve decides two months into the year to raise interest rates by 0.25%. Three months later, they raise rates again by 0.25%. However, a sudden shock to the market occurs as unemployment rises sharply and more mid-major banks collapse due to the tightening policy, so they decide to lower interest rates by 2% By using a CD ladder, you would capture the following:

First deposit: $2,500 at 5.25%
Second deposit: $2,500 at 5.50%
Third deposit: $2,500 at 5.75%
Fourth deposit $2,500 at 3.75%
Average yield: 5.063%

While this average yield is worse than the original 5.25% offered, keep in mind that after a year, in the base case the money would either need to go back into high-yield savings or will instead be earning 3.75%, far less than half of our ladder still earning 5.50% and 5.75% or the average yield of over 5%. If rates were to pick back up in the following year, your deposits could take advantage of the rate recovery and far less of your CDs would ever yield 3.75% – you would earn considerably more. But if you only had one decision point a year, your money could earn a lot less due to the misfortune of poor market timing.

Conclusion

Certificates of Deposit are starting to offer an opportunity for savers to earn considerably more on their savings without having to sacrifice key protections such as lack of exposure to the market and FDIC protection. However, it is important to consider an approach that minimizes market timing and volatility risks in an effort to combat inflation and to avoid having bad luck affect the long-term balance of your cash. Deploying a CD ladder can be a terrific way to preserve stable growth and optionality for the long run.