While online savings accounts offer good rates, we can boost returns (for very little risk) with a CD ladder.
Why it works: In return for locking up your money for a fixed amount of time, banks are willing to pay you a higher interest rate on your money. For example, ING Direct pays an APY 2.75% for money in its online savings accounts. In contrast, a 1 year CD at ING Direct pays 4.00%. As you can see, you are earning more interest on the same amount of money.
How it works: By investing your money in CD's that mature at regular intervals, you get the benefit of higher interest rates without having all your savings out of reach.
Example of Simple CD Ladder: You have $4,000 to invest and want to have a one year ladder. Buy four $1,000 CDs with terms of 3mo, 6mo, 9mo, and 1 year. When the 3,6,9 mo CDs mature, replace with a a new 1 year CD. Ultimately, you end up with four 1 year CD's. Should you need the money, one of them will be maturing every 3 months. My bank, ING Direct, will automatically reinvest maturing CD's for you.
Example of Complex Two Year Ladder: Let's say you have $24,000 to invest, you could set up a ladder of 2 year $1,000 CD's maturing every month. Ultimately, the complexity of your ladder is up to you as the combinations are virtually unlimited.
Risk: If you have an emergency and need to get your money early, you will get all of your principal back. You will, however, forfeit some of the interest earned. The money invested in a CD ladder should be money you do NOT expect to need in a "common" emergency (car breaks down, medical bill). The longer the term of your ladder, the more risk you have of having the dreaded "early withdrawal" penalty. In my case, I use a one year ladder because I like the idea of accessing 100% of the money within 12 months.
Bonuses to look for:
- Size Matters: CD's have transaction costs for the bank. As a result, they are likely to incentivize, with higher interest rates, you to have fewer, bigger CD's. In the case of the 2 year ladder described above, it is likely you would be better off buying four large CD's instead of 24 small CD's. So-called "Jumbo CD's" may be a good idea for some investors.
- Time Periods: Although banks often pay higher interest rates on longer term CD's, the "best" rate is not always the longest available.
NEVER, EVER DO THIS: NOT EVER
- Invest in CD's of foreign banks. Many an investor has been scammed by con artists promoting "guaranteed" CD's in banks domiciled outside the US.
- The FDIC is your friend. Do not invest in CD's lacking FDIC insurance. In addition to making sure you do not invest in banks lacking insurance, make sure you do not invest money in excess of the FDIC limit (currently very high).