How to make a CD ladder work for you

Even if you don't have one, you're probably aware of what a certificate of deposit, or CD, is. Maybe you have one now as part of your financial plan. Or maybe you'd like to get one if rates are more favorable than the rates your savings account offers.

It's true that CDs appeal to many people. CDs typically give you an opportunity to earn more than you would in a savings account without the worry that you could lose what you put into it.

A CD ladder can be a savvy approach that can help you earn a little more interest while gaining extra flexibility when it comes to accessing your money. Read on to learn what a CD ladder is, how to build one, and if it makes sense for you.

What is a CD ladder?

Before we get into the ins and outs of a CD ladder, let's start with the basics.

A certificate of deposit, or CD, is a low-risk savings vehicle. You give the bank a certain amount of money that is held for a specified term you choose. In return, the bank pays you interest. When the time's up, you get your money back plus the interest that was earned on that particular CD.

CDs have plenty of benefits. They generally come with no fees unless you withdraw the funds before the CD matures, which is discussed more in the next section. They're generally FDIC-insured, and they're ideal if you want to save for one-time expenses like home improvement projects or vacations. Also, in most cases, your interest rate's locked in, which means yours won't decrease if interest drops during your CD term. This is called a fixed-rate CD. There is also a variable rate CD with an interest rate that can vary based on the terms set by the bank. In the case of a CD ladder, we're using fixed-rate CDs.

But CDs also have some drawbacks. One is that you're typically penalized for taking your money out before the CD matures, as mentioned above. If you do, you may have to pay a penalty that could erase some or all of your interest earnings. And while you're able to lock in an interest rate with fixed-rate CDs, you'll be stuck with a lower rate if interest rates rise before your CD matures.

What if there were a way to have the proverbial CD cake and eat it too?

Enter the CD ladder. With this approach, you obtain multiple CDs — usually four or five — at a time. The goal is to blend longer-term CDs with shorter-term CDs so they have staggered maturity dates.

How a CD ladder works

Imagine that you decide to apply for a CD, and you're comparing your options. You could obtain a CD that matures in one year, or one that matures in five years. The second option may have a higher interest rate because of the longer term, but what if you need your money sooner than five years from now?

Before we begin to discuss the strategy behind the CD ladder, it's important to note that there are times when this does not work exactly as described here. That's when we're under an inverted yield curve, meaning long-term interest rates are lower than short-term interest rates. For example, a 6-month CD might be at 4.5% APY, while a 5-year CD might be at 3.5% APY. The strategy here is most effective when long-term interest rates are higher than short-term interest rates.

With the CD ladder approach, you take the amount you have and divide it into five CDs. We'll use $5,000 for this example.

When your first CD matures after one year, you have a choice. You can get your cash back and collect your interest, or you can decide to obtain a new CD.

If your goal allows, applying for a new CD is a good idea. That means you roll your money, including interest, into a new 5-year CD, adding a new step to your CD ladder. And because you've decided to save in a CD ladder instead of one individual CD, you can feel more comfortable about getting that new, 5-year CD. Another CD matures each year, so you'll have another chance to access each CD or renew them again.

That's the difference between a CD ladder and a single CD. Even if interest rates stay low, your average interest rate could be higher with a CD ladder than if you obtain one CD every year or every five years.

Using CD ladders when interest rates are low

Remember when we talked about the drawbacks of a CD, and we said you run the risk of locking in an interest rate, only to watch rates rise before your CD matures? Luckily with a CD ladder, your CDs mature at an interval you set up. So if interest rates start to rise, you periodically have the opportunity to obtain a CD at a higher rate.

And if interest rates drop, you'll be happy you locked in the rate you did and have the flexibility not to renew if rates are low.

While interest rates are always changing, lower rates may mean there's not a huge difference between the interest rates of a 2-year and 5-year CD. But in the past — even in recent years — longer-term CDs could earn more than shorter-term CDs.

Unless, as mentioned before, we're in an inverted yield curve. It's important because even half of a percentage point makes a difference over time, due to compounding interest.

When people think about CD laddering, they usually think about splitting their lump sum evenly among each CD. This is a good move because it gives you a wide safety net. But another option is to distribute your money strategically depending on whether you expect interest rates to rise or fall. This approach is called "uneven splits."

If interest rates are rising, you could consider saving more money in shorter-term CDs so you have plenty of opportunities in the future to reinvest in CDs with a higher interest rate. On the other hand, if you expect rates to fall, you'll be glad you locked in a larger percentage of your money with a higher-interest rate.

It's worth noting that when interest rates are low, you run the risk of losing money to inflation in the long term. For shorter-term savings goals, CD ladders could be the solution you need. But for long-term savings, such as retirement, consider other savings vehicles, such as investments, which can hopefully provide a growth rate that outpaces inflation.

The USAA Advice Center provides general advice, tools and resources to guide your journey. Content may mention products, features or services that USAA Federal Savings Bank does not offer. The information contained is provided for informational purposes only and is not intended to represent any endorsement, expressed or implied, by USAA or any affiliates. All information provided is subject to change without notice.