NEW YORK (MainStreet;) - CD laddering is a common tactic for getting the most out of your emergency savings. The rate will be better than in a savings account. What's more, you can't touch it without a penalty, thus eliminating the temptation to see a new leather jacket as an "emergency need." But what is CD laddering? How does it work? Perhaps most importantly, is it still a smart move in an economic climate where interest rates are in the basement?
What Is CD Laddering
In the simplest possible terms, CD laddering is where "the investor buys CDs with different maturities," explains Devang Patel, a financial advisor with the MetLife Premier Client Group. Why would you want to do that? "You end up getting a higher interest rate over time while preserving liquidity," Patel says.
In layman's terms, a CD ladder makes it so that you have multiple CDs maturing during regular intervals, typically six months or a year.
For example, if you have a six-month, year-long and 18-month CD, you'll be able to access money every six months while also getting the benefits of the longer-term CD.
"The longer you have the CD, the higher the yield you're going to have," Patel said.
You still get maturity every six months, while also enjoying the higher interest rate on the longer term CDs. That's the what and the why of laddering.
What's the Best Use of CD Laddering?
Patel suggests that "if you're getting retired or close to retirement and using the bucket strategy, you can have money coming due every six months with CD laddering." The money that comes due can then be your budget for the next six months. What's more "for our clients who are accumulating money, you're almost using this for emergency funds," in addition to using CD laddering for income.
What this means is that if you have 18 months of emergency funds saved up, you can put these into three different CDs of six months, a year and 18 months.
Bijan Golkar, a certified financial planner with FPC Investment Advisory, recommends that you not put your money into a CD unless you have a significant sum to contribute.
"You'd want to do at least $10,000 per CD and then go up from there," he says.
"If you're going to buy a house in the next year, you can put it in CDs," he adds. You'll want to keep it under the FDIC limit to keep your money secure, but it's better to have that money making money for you than just sitting in the bank.
"It's a non-trivial amount of money at that point," he says.
Should You Start CD Laddering?
Golkar is very direct: "I would not recommend that anyone does a CD laddering trick."
Why not? "Even cash is a risk and that risk is called inflation," he says. "If inflation picks up again, which it will, your money will be locked into these CDs. Even if it's laddered you're going to be eroding a lot of purchasing power."
Patel is more or less on the same page.
"The interest rate environment isn't great for the shorter term," he says. "It's not that much different than putting your money into a money market account. In fact, that might be a better approach if you can find a special introductory rate."
The final word? Keep large sums for a house down payment in CD ladders. That way you can't touch them and they can make some money for you. Otherwise, use shorter-term CDs to pay yourself as part of a bucket system. If you don't fall into either of those categories, you need to wait for interest rates to go back up before this is an attractive option.
--Written by Nicholas Pell for MainStreet