I’ve been thinking about this for quite some time, but today’s post from DoughRoller with A Dead Simple Alternative to CD Laddering was the icing on the proverbial cake. And I think that DoughRoller is right. Or at least, what DR says is in line with what I’ve been thinking too.
Here’s the basics. A CD Ladder typically is made of several 1 YR CD’s whose maturity dates has been staggered such that a new one is maturing about every 3 months or so. Depending on the variation, some may even have one maturing every month. It’s all in how you stagger the CDs. Because you have them staggered, your money is never completely locked away and you can always get to some of it every month or three months. So, any non-emergency expenditure can be planned for and the money from the most recent maturing CD can be used to pay for the expenditure. At some point, you replace the CD and all is back to where it was.
My problem with all of that is that if you split $10,000 over 4 CDs, you get 4 $2500 CDs. If you split it over 12, you get 12 $833 CDs. That’s great, but what if you need to spend more than that? You have to cash more than one CD. Or you have to wait even longer until more of the money is freed up. It’s not a catastrophe. But it’s inconvenient. On top of all that, you’ll likely pay a penalty on any extra CDs that you decide to cash out. Again, not a catastrophe.
The solution, as DR and I see it, is to take that $10,000 and dump it into a long term CD. Say a 5 year CD. Yes, if you need the money before that 5 years is up, you will still pay a penalty. But, the penalty is generally something like 3 months interest. So, as long as you’ve held the CD for longer than 3 months, the worst you can do is break even. If you cash it out in less than 3 months, you either didn’t plan well in the first place or you really have an emergency and you probably won’t notice a few months interest. The main advantage of this method is that all of your money is available to you at all times. A secondary, but nearly as important advantage, is that the long term CDs generally pay higher interest. So, if you leave the money for the full 5 years, you will have made significantly more interest than you would have with 4-12 1 YR CDs.
Rate examples (as of March 31, 2010)
- ING Direct: 1YR CD = 1%, 5 YR CD = 1.25%
- HSBC Advance: 1 YR CD = 0.40%, 4* YR CD =1.70%
- Ally: 1 YR CD = 1.54%, 5 YR CD = 2.99%
As you can see, there are some pretty significant differences in rates between a 1 year CD and a 5 year CD. Ally only has a 60 day early withdrawal penalty. HSBC only has a 30 day penalty. ING has, by far, the worst penalties for early withdrawal. Any CD over 12 months term will incur a 6 month penalty and any CD 12 months and under will incur a 3 month penalty. Looks like Ally is the place to go.
I think the strongest point for this type of CD investing is that I don’t like losing that extra interest because of a “maybe”. Yes, “maybe” I’ll need that money before that 5 years is up. But, I may not need it at all. And if that’s the case, I’d rather be earning the higher rate. And if that “maybe” comes around? Well, hopefully I’ll have had the CD long enough to override any penalty that comes with that. At worst, with those examples above, I would only need to hold the CD for 6 months before it would be an even transaction. Sure, I lose that interest. But, again, that’s only a “maybe”.
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This is a good point. The better way to accomplish this is to buy brokerage CDs which you can sell and still keep your interest. By dealing with a brokerage firm, you have a wider option of interest rates and you receive interest payments during the year.
Brokerage CDs may pay slightly less than an issuing bank will pay but you have more options of banks which usually means you can actually find higher yields.
Another added option is that you can buy callable CDs which will offer an even higher yield than any CD that a bank will issue on its own.
You’re not comparing the same things. Your CD ladder has 1YR CD’s staggered over 3 months, but the long term CD is a 5 Year one. To make this an apples to apples comparison, try comparing the rates of five 5-year CD’s staggered by 1 year each to a single 5 year CD. Now you have comparable maturity rates and you are getting the 5 Year rate on each CD. And if you need just 3K for an emergency, you’ll lose penalty on just the 1 or 2 CD that you need to break instead of losing interest on one big 5 Year CD.
Also, you’re missing another advantage of laddering. Right now interest rates are low and they will surely increase as the market goes up. By buying a 5 year CD right now you’re locking yourself to a low rate while laddering will let you jump in if hte rates go up next year.
I think if you compare things right, CD ladders are definitely worth it. Especially, with banks like ING, they automatically setup the CD Ladder for you. So there’s no additional work involved as well. What’s not to love?
@retiredat40, I’ve never heard of either of those options. Where can I go to check them out?
@Srinath Dev, You are partially correct. The problem is that in order to ladder 5 5-year CD’s, it would take 5 years to do it. That’s a lot of potential interest that you would either be losing or earning at a much lower rate while you were waiting to purchase your next CD. Also, Yes, rates may go up. But, unless they go up significantly in a short period of time, the same thing applies. I could just as easily eat the two months interest penalty and then repurchase a CD at a higher rate. But, you’re still investing on “maybe” there. Rates “maybe” will go up. A bird in the hand and all that.
For the record, I do like that ING sets up the ladder for you. And if the rates at other institutions 5 yr CDs weren’t over 1% higher, it would well be worth it.
The best place to buy CDs is probably with Fidelity Investments. They usually have the widest variety and you don’t have to pay anything to buy one. Schwab is probably No. 2.
You can even buy CDs that other people are selling and sometimes find a good deal that way but that is a little more advanced and I will not go into that.
You just open up a brokerage account with a company, deposit your money and buy the CD which can be done online.
To review Fidelity’s present inventory of CDs, you choose Fixed Income from the Research tab on Fidelity.com and then select FDIC-insured CDs.
Interesting ideas and discussion–especially since I’ve decided it’s time to do *something* with our emergency funds. . .I’ll be mulling these over soon . . .and I didn’t realize ING had such bad penalties for early withdraw. I’ll have to check that out. . .
I still prefer to stagger them in a way that they mature yearly. This simplifies the ladder process since you only have to deal with a maturing CD every year.
I.E. Start off with $10,000 divide into 1 yr, 2 yr, 3 yr, 3 yr and 5 yr CDs evenly. Every time a CD matures roll it into a 5 year CD. Over time you’ll have a 5 year CD maturing every year. I prefer this rather than dumping it all into one CD because it’ll average out the interest rates.
Also if you needed $2k in a pinch you wouldn’t be hit with the 2-3 month penalty on the whole 10k. If you needed the whole 10k the penalty from 5 CDs would equal that of one CD regardless.