I have most of my cash in a high-yield savings account making 4.12% APY. However, in previous days when the yield curve wasn’t so flat, a technique called laddering along with certificates of deposit (CDs) was pretty popular.
For example, let’s say you had an emergency fund of $5,000. You want to keep that pretty liquid and safe, but you also don’t want it sitting there getting eaten up by inflation. So, you put $1,000 in a savings account, $1000 in a 1-Yr CD, $1000 in a 2-Yr CD, $1,000 in a 3-yr CD, and $1,000 in a 4-Yr CD. You would end up with better overall interest rate, and take an interest hit if you needed to take out more than $1,000 in a year by breaking the older CDs. Now, when the 1-Yr CD matures, you go out and buy another 4-Yr CD, keeping the ‘ladder’ intact (The old 4-Yr CD now has 3 years to go, etc). For a while, the increase in interest by doing this was not worth the loss in liquidity. Let’s check again:
I’ll use INGDirect as an example since they are OK in the interest rate department, and their CDs are very flexible since you can open them with any amount. You could make a small $600 CD ladder with their savings account and 1,2,3,4, and 5 year CD in $100 increments. There are definitely many banks with higher rates out there.
So, if you kept $5,000 in their Orange Savings Account (OSA), you’d currently get 3.40% APY, or $170 in a year.
Let’s look at if you make the following ladder with the current rates:
$1,000 OSA at 3.4% APY
$1,000 1-Yr CD at 4.2%
$1,000 2-Yr CD at 4.5%
$1,000 3-Yr CD at 4.65%
$1,000 4-Yr CD at 4.7%
—————————
$5,000 Ladder earning 4.29% APY
That’s an increase of 0.89% annual interest. Equivalently, you’d get $214.50 in a year, an increase of $44.50 or 26%. Not bad if you do have money at ING.
Remember that you are giving up liquidity by doing this. ING charges a penalty of 6 months interest for breaked a CD with a term longer than 1 year. Be aware that if you break in less than 6 months, you’ll actually be losing money! But, it may be worth it. Now I need to see if I can find a bank with consistently high rates to open a up a ladder with better rates. It would have to be all at one bank, otherwise it’d be a pain to keep track of.
You can do alot of different things with laddering – make the time increments longer, shorter, wider apart, closer apart, and so on. Many people also use this technique with marketable bonds and savings bonds.
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Seems like a lot of work and risk if you can just get a bank account with 4% interest at ED.
I don’t like ING’s policy of charging six months of interest. Most banks and credit unions charge 3-months and will match ING’s CD rates.
Great post. I applied this same approach at several banks and found GMAC Bank to have the highest average rate of 4.52% (I’ve included a link to your post in mine 🙂 But if you replace the 2, 3 and 4-year CDs with the 1-year CD, the average rate just goes down to 4.43%. So I don’t think there’s enough benefit to go longer than a 1-year CD.
Although savings accounts are offering +4% interests I still believe CD laddering is an important concept to understand. Eventually CD rates will surpass regular savings by a margin that will warrant the laddering. I currently have all my money parked at EmigrantDirect, but this could change depending on the rates of short term CDs.
First of all, if its for an emergency fund, 1 yr CDs are a not-so-great idea, unless your rungs are each a year’s salary.
I use I-bonds myself. There’s been a lot hooting about them lately, because of the very tempting possiblity of 7% interest, but even right at this very moment, I-bonds are paying 4.8%. At least in the last year or so, I-bonds have been running at least .5% higher than the best CD rates.
And they are tailor-made for laddering – as a matter of fact, to get the best tax advantages – its best to buy a bit every month rather then plunk everything down all at once.
For emergency monies, in the cash portion of our portfolio, we have three 3-month cds, that come due & roll over, one every month. Each CD was launched with slightly more than our monthly expenses; and keeps up with inflation; we both work, so we’re hedging against a loss of one job, or an unexpected tragedy; it’s in a highly rated FDIC bank, high yielding from bankrate.com. I don’t fret about the loss of a basis point here & there–my time is worth so much more; it’s all on automatic pilot; and use I-bonds for a portion of our fixed income portfolio.
Laddering is a good option when interest rates are in a flux and there doesn’t seem to be a good notion of whether they will go up or down. When there is a trend with the Federal Reserve to increase interest rates (as there is now), it makes little sense to ladder in my opinion.
In response to the previous comment, the Fed trend to increase interest rates makes sense to SHORTEN the ladder – not stop it altogether.
For example, in the current environment one might buy (and plan to continually renew) the best available 1-month, 3-month, and 6-month CD’s and/or T-bills. When the Fed rate hike is no longer such an obvious forecast, (s)he would then start to renew some of the shorter maturing investments into longer maturities. And if a rate drop were ever as apparent a trend as the current rate hikes, well then that is the time to extend your ladder to the longest maturities.