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What is CD Laddering?

Laddering refers to the strategy wherein a specific amount of money to be invested is divided more or less equally between two or more certificates of deposit or CDs, each maturing at different times though typically year after year. Laddering strikes a near-perfect balance between cash flow and return on investment because investors can receive a steady stream of income while they enjoy higher interest rates on the remainder of their investment over the next few years.

Investing in CDs is a wise move because they have higher yields than money market accounts and they are insured against price fluctuation, thus making them considerably safer alternatives to stocks. The downside is that the total amount of money that has been invested in them-plus interest less bank charges-will not be available until their respective maturity dates. Early withdrawal of CDs is possible if an investor needs the funds very badly but banks charge high corresponding penalties for any amount withdrawn even just one day before maturity, and the interest may also be offset by the penalties in the case of very early withdrawals. Some CDs pay out accrued interest periodically until the end of the term, but the amounts are usually so small that most investors decide not to bother with them and instead wait for the principal and the accumulated interest upon maturity. Laddering is a means to offset these problems faced by many investors today, and the best way to explain the process is by example.

Investing teaches that the longer the term of a fixed-income security, the higher the interest rate will be and it will remain so until the end of the term. An investor who wants to benefit from a 3.2% rate for a 5-year CD may also want to withdraw some of the funds for his or her own use well before the maturity date. A shorter-term CD allows an investor to get all of his or her money back earlier, but the interest will not be as great. An investor may choose to invest his or her money in CDs of equal principal but with different terms and interest rates.

Once the first CD matures at the end of the first year, the investor takes whatever amount he or she needs and then invests the remainder, as long as it doesn't fall below the minimum required principal, in a 5-year CD. This, in effect, is the new 5-year CD because the earlier 5-year CD has now become a 4-year security in light of one year having gone past though its original interest rate of 3.2% is the same. The earlier 4-year CD is now a 3-year CD, the earlier 3-year CD is now a 2-year CD, and the earlier 2-year CD now has only a year before it matures, but their respective interest rates have not changed. The rate of the new 5-year CD may or may not be as good as the 3.2% from the earlier 5-year CD, but investing in it is still a more profitable option when compared to investing in a CD of shorter-term-which isn't really necessary anyway if shorter-term CDs have already been bought the previous year-or in more liquid securities like money market funds and stocks.

The process of laddering may continue for as long as an investor wishes to keep his or her securities set up in such a way that there will be both periodic cash flow and a substantial interest on the remaining holdings. An investment will grow substantially if an investor repeatedly grabs opportunities for high interest rates on long-term securities, and laddering also gives him or her opportunities to reap some of the benefits much earlier. Since laddering is done at the discretion of the investor and not the financial institution, it can be done with more than one bank. Some people invest their money across two or more banks since some financial institutions offer better terms and rates than others.

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