How to Create a CD Ladder for Your Emergency Fund (and Why You Did It)
This financial step requires a little work, but it’s arguably the best way to maximize interest on your emergency fund during a time of high inflation: it’s called the CD ladder – a series of overlapping certificates of deposit that expire at different times, so you have stable cash flow that still uses long-term interest rates. This is how it works.
What is a Certificate of Deposit?
The CDs are actually pretty simple: you give the bank a lump sum of money in exchange for not withdrawing funds for a specified period, from three months to five years. Instead, you can fix the annual interest rate for this period (the longer the period, the better the rate).
The advantage of CDs is that they are considered a safe way to hide your money and usually bring in more interest than checks, savings and money market bills (currently closer to 1% per annum versus 0.50% per annum). The downside of CDs is that there is a fee for early withdrawals, which essentially negates any interest you charge.
Okay, but what is CD Ladder?
The CD Ladder is a savings strategy where you invest in multiple long-term CDs with spaced expiration dates so that you have a steady flow of cash at regular intervals without having to withdraw money ahead of time. For example, at $ 10,000, the CD ladder would look like this:
- $ 2,000 on a one-year CD
- $ 2,000 on a two-year CD
- $ 2,000 on a 3-year CD
- $ 2,000 on a four-year CD
- $ 2,000 on a five-year CD
Then, when the CDs reach maturity, you put that money into a five-year CD like this:
- $ 2,000 (plus one year) on a five-year CD
- $ 2,000 (plus two years at interest) on a five-year CD
- $ 2,000 (plus three years interest) on a five-year CD
- $ 2,000 (plus four years interest) on a five-year CD
- $ 2,000 (plus five years interest) on a five year CD
In doing so, you maximize long-term interest rates while giving yourself some flexibility in using cash if you need it, since the CD expires every year. (To learn about the best interest rates on CDs in September, check out this post “Bankreyt” ).
There is some risk in this as you will not have all the cash available unless you want to cash out early and lose interest on the principal. For this reason, you can only invest a fraction of your emergency fund in the CD ladder.
Why don’t I just put this money into stocks?
A couple of reasons: risk and liquidity. There is always a risk that you could lose your money by investing in stocks and it may not always be easy to sell your stock at a favorable rate when you are in an emergency. Plus, you always want to have some cash on top of your investment.
Bottom line
While a CD is less liquid than a savings account (which allows you to withdraw money without penalties), it will generate more interest . Of course, interest rates are very low right now, so this can only add a few hundred dollars to your cash reserves, but it’s better than nothing. You can experiment with this CD ladder calculator to see if it’s worth it for you.