A CD ladder is a way of investing your money in certificates of deposit (CDs) with different maturity dates. CDs are savings accounts that pay a fixed interest rate for a fixed period of time. You can’t withdraw your money before the maturity date without paying a penalty.
A CD ladder can help you generate passive income from your savings while keeping some flexibility and liquidity. Passive income is money that you earn without much effort or involvement.
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How a CD Ladder Works
- You divide your money into equal parts and invest each part in a CD with a different term. For example, if you have $10,000, you can invest $2,000 in a one-year CD, $2,000 in a two-year CD, $2,000 in a three-year CD, $2,000 in a four-year CD, and $2,000 in a five-year CD.
- You choose CDs with the highest interest rates for each term. Longer-term CDs usually have higher rates than shorter-term CDs.
- You wait for the CDs to mature. Every year, one of your CDs will mature and pay you interest and principal. For example, after one year, your one-year CD will mature and pay you $2,040 (assuming a 2% interest rate).
- You reinvest the matured CD in a new CD with the longest term in your ladder. For example, after one year, you can reinvest the $2,040 from your one-year CD in a new five-year CD with a higher interest rate.
- You repeat this process every year until you need to use your money or stop the ladder.
The Benefits of a CD Ladder
- You can generate passive income from your savings without taking much risk. CDs are insured by the FDIC up to $250,000 per depositor per bank.
- You can take advantage of higher interest rates on longer-term CDs while still having access to some of your money every year.
- You can adjust your ladder to changing interest rates and financial needs. If rates go up, you can reinvest your matured CDs in higher-rate CDs. If rates go down, you can keep your existing CDs until they mature. If you need more money, you can cash out one or more of your CDs (but you may pay a penalty).
The Drawbacks of a CD Ladder
- You may earn less than other investments that have higher returns but also higher risks. CDs are safe but conservative investments that may not keep up with inflation or beat the stock market over time.
- You may lose some of your interest income if you withdraw your money before the maturity date. Most CDs charge an early withdrawal penalty that reduces your earnings.
- You may have to pay taxes on your interest income every year. Unless you invest in tax-exempt or tax-deferred CDs, such as municipal bonds or IRAs, you will have to report and pay taxes on your interest income every year.
Conclusion
A CD ladder is a simple and effective way to generate passive income from your savings while keeping some flexibility and liquidity. However, it may not be suitable for everyone or for every financial goal. You should consider your risk tolerance, time horizon, income needs, tax situation, and other factors before investing in a CD ladder.
As of the writing of this article, the best interest rates on CDs is currently paying as high at 5.25% and up, depending on the specific terms of the CD. The Federal Reserve is currently performing interest rate hikes and is likely to continue to do so for the foreseeable future. This will push interest rates even higher on CDs, so now is the best time in a long time to start a CD ladder.
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