CD laddering - the all-in-one strategy for high returns, safety & liquidity
CD laddering is a simple but really cool strategy of earning relatively high interest with maximum saftey and high liquidity.
How is that possible, you will ask? Isn't there always an inverse relationship between risk, return and liquidity?
Well there is, and most financial strategies try and find a balance between these three requirements. CD laddering is one such strategy that is easy to understand, easy to follow, requires no financial background and has almost zero downside.
What's the catch?
It takes patience to set up a CD ladder. That's why many people fail to set one up. But if you're able to, the advantages are tremendous.
(A quick comment here. CD laddering can be set up in any country and although I'm including it here, it is not really unique to moving to America. But hey, use your relocation to the US to re-look at your financial goals afresh and evaluate CD laddering too, if you haven't already!)
So how does it work?
Well, lets first understand what a CD is. A CD stands for a Certificate of Deposit. It is the equivalent of a 'fixed term' deposit that you find in other countries. Banks or financial institutions offer CDs for a standard timeframe (usually 3 months, 6 months, 9 months, 1 year and so on upto 5 years). During this period, you get a fixed interest rate, usually higher than what you would get in any savings account. CDs are FDIC insured, and hence guaranteed by the government to the tune of $250,000 each. In return for this high return and high security, you lose out on liquidity. You are prohibited from withdrawing money prior to expiry of the CD. If you do, you are charged a high penalty, negating any returns made on the money.
CD laddering is a technique that helps you get around the liquidity problem.
- First you choose the level of liquidity you need. For instance, you could decide to withdraw money every year, or every two years. You could choose a shorter period too, say every 6 months or every month. The shorter the period, the more 'rungs' to the ladder you'll have to build (i.e. the more the effort and capital required).
- Lets assume you decide on yearly liquidity. Now search the market for a CD that gives you the best 5 year interest rate, the best 4 year interest rate, the best 3 year interest rate down to the best 1 year interest rate. The 5 year CD will always give you the maximum rate of interest.
- You divide your money into 5 equal parts and invest in each of the above CDs.
- At the end of the first year, the '1 year duration' CD will expire. Take out the interest (if you like) and reinvest the principal in another 5 year CD.
- At the end of year 2, the '2 year duration' CD will expire. Once again, take out the interest and reinvest the principal in a 5 year CD.
- Do this at the end of years 3 and 4 as well.
- At the end of year 5, your first '5 year duration' CD will expire. At this time, you would only possess 5 year duration CDs because you've been re-investing only in those. But, all of them would be due to expire successively each year thereinafter. And all of them would be earning the maximum possible interest (since 5 year CDs enjoy the highest interest rate).
The net result: you've built a 'ladder' of CDs with a CD expiring every year. This gives you yearly liquidity, at a 5 year CD's high interest rate, with FDIC backed security.
Returns, Safety, Liquidity. Voila! You get it all.
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