Explain a CD ladder please

[OAG]

what is the duration of the ladder (all 10 year CDs?, all 8 year CDs, varying maturities?)? Do you keep the rungs in equal increments? when a CD matures do you stay at same bank or shop around?

Do you feel your return has beaten money markets over same time period?

I usually buy the longest CD (with the highest rate), be it 10, 7 or 5 years. I really don't shop around (beyond the three CU and Bank I have used over most of the period). I try to keep the rungs equal in maturity value, but that is not always possible (for instance in 2010 about 25% will mature, but that is the year we plan to purchase a new car and may relocate to another part of the country). MMA are relatively new to me (last 15 years or so) and I usually could beat them in rates on long term CD's. I have started to use a MMA currently, however (HBSC 3.5% FDIC rate).

 

[Khan]

I was in the process of building a CD ladder for a projected retirement on Feb '08.

I retired somewhat suddenly in Dec '04 and the CD ladder was not complete; I am still working on it.

The idea was 5 $20,000 CDs, one maturing every year, taking off the earnings and rolling over the principal.

4k or 5k per year income supplement.

That will start in Dec '09.

 

[harley]

I'm appending this to this old thread, since the basic topic has already been covered fairly well here. However, I have a few specific questions I hope y'all can help with. My Mom (73) has her pile of money that she insists on keeping in cash. She lives on her SS and VA bennies, and uses the interest from the cash for luxuries and unexpected expenditures. I was going over her holdings with her recently, and IMO she needs to update her methods.

She currently has ~$250K in CDs, and ~$200K in savings and checking accounts. The savings accounts are paying basically nothing. She has been buying short term CDs (6-9 months) so she is now facing 1-2% yields as they come due. I told her about a CD ladder, which was a new concept to her. She's interested, but would like me to design a strategy for setting it up.

I understand the normal process for setting up a ladder (buy 1, 2,...5 year CDs, then buy 5 year CDs each time one comes due). I suspect she's going to complain about locking in the incredibly low rates currently available (3-4% for a 5 year). But I don't see any real way around it. At least without venturing into something extremely risky like a short term bond fund. If anybody has any good suggestions on this I would appreciate it.

The second part of my quest for advice is this: If I do get her to ladder the CDs as above, and interest rates go up significantly say 3 years down the road, would there be a big issue with early withdrawal of the older low rate CDs? Is it just a question of determining if the new rate would overcome the penalty? And what are normal penalties for a 5 year CD? Loss of a year or so interest? If I could tell her she could bail on a low rate CD if the rates goup it might make for a better sell for the method.

I would appreciate any and all opinions. Thanks.

 

[clifp]

I understand the normal process for setting up a ladder (buy 1, 2,...5 year CDs, then buy 5 year CDs each time one comes due). I suspect she's going to complain about locking in the incredibly low rates currently available (3-4% for a 5 year). But I don't see any real way around it. At least without venturing into something extremely risky like a short term bond fund. If anybody has any good suggestions on this I would appreciate it.

The second part of my quest for advice is this: If I do get her to ladder the CDs as above, and interest rates go up significantly say 3 years down the road, would there be a big issue with early withdrawal of the older low rate CDs? Is it just a question of determining if the new rate would overcome the penalty? And what are normal penalties for a 5 year CD? Loss of a year or so interest? If I could tell her she could bail on a low rate CD if the rates goup it might make for a better sell for the method.

I would appreciate any and all opinions. Thanks.

This is a good question so I did a bit of research at PenFed
For CD between 6 months and 5 years, the penalty is 180 days of the most recent interest earned. So at current rates this will be a bit over 2% (due to compounding). You are slightly better off taking the penalty if at the end of the first year you can replace the 4% 5 year CD with 4 year CD earning 5% or more.

One of my resolution after this market is to set up a small CD ladder knowing that the penalty isn't too severe is helpful to overcoming my natural reluctance to CDs.

One thing I noticed while doing research it appears that CD you buy through a broker like Schwab or Vanguard don't have an early withdrawal penalty, but they also don't have the option to redeem them early. Instead you have to sell them in the secondary market which means they would probably sale below par value.

Am I correct in assuming that if interest rates go up a lot you are better off getting a CD directly from bank or credit union than a broker?

 

[Rich_by_the_Bay]

As long as we bumped this old thread, I confess I never thought CD ladders added much. Other than a theoretic twinge less risk, I can't see their advantage over a good quality short term bond or even a short term federal bond fund. Returns seem comparable or better for the bond fund, both are stable, and the fund is liquid with checkwriting, etc. any time you wish, and no early withdrawal penalties or yearly purchasing hassle.

FDIC coverage, granted. Anything else compelling in favor of CDs?

 

[clifp]

As long as we bumped this old thread, I confess I never thought CD ladders added much. Other than a theoretic twinge less risk, I can't see their advantage over a good quality short term bond or even a short term federal bond fund. Returns seem comparable or better for the bond fund, both are stable, and the fund is liquid with checkwriting, etc. any time you wish, and no early withdrawal penalties or yearly purchasing hassle.

FDIC coverage, granted. Anything else compelling in favor of CDs?

Well as a former investor in the Schwab Yield Plus short term bond fund, which has average maturity of less than 1 year, and yet managed to lose -35% percent last year (and -10% this year), I can insure that twinge less risk is not merely theory. While Schwab Plus was the worse short term bond. M* say that 22 out 123 short term bond funds had double digit loss last year. So CD is defintely safer. The beauty of the CD is unlike a bond fund you can't lose money. Now government securities (if held to mature) also you can't lose money.

Thanks to the governments recent backing you can't lose money in a money market but A CD ladder generally offer higher return. For instance while 1 year 2% CD or a 5 year 4$ CD at Penfed are nothing to get to excited about compared the .36% I am getting on my Vanguard or Schwab money market funds.

The other valuable thing about CD is the ability to reedem them for modest penalty (about 2% for a 5 year CD) not just in the event of an emergency, but also if interest rates rise.

I never considered the implied put (i.e. the ability to send the lender the keys) that came with a mortgage to be that big of a deal. However, recent events have proved that it is a valuable thing. If we see a big spike in interest rates, the value of even intermediate 2-5 year bonds or bond funds will drop considerably, 10-20% is certainly possible. However with a CD ladder you can catch the rise in interest rates pretty easily, and are locked into to higher rates when interest rates fall.

 

[Maurice]

If you're concerned about low 5 year CD rates, maybe do a three year ladder for now. Its still much better than earning 0% in her checking and savings.

Also make sure you use different banks to keep below the FDIC limit.

 

[Rich_by_the_Bay]

Well as a former investor in the Schwab Yield Plus short term bond fund, which has average maturity of less than 1 year, and yet managed to lose -35% percent last year (and -10% this year), I can insure that twinge less risk is not merely theory. While Schwab Plus was the worse short term bond. M* say that 22 out 123 short term bond funds had double digit loss last year. So CD is defintely safer. The beauty of the CD is unlike a bond fund you can't lose money. Now government securities (if held to mature) also you can lose money.

Points taken, though that fund is the target of massive class action suites, was inconspicuously 50% in mortgage related holdings, etc. For my safe money I probably won't choose any fund with the terms "Yield Plus" in the name .

My Vgd Short-term Federal fund is up 6-7% or so for the last year or ten and has been rock solid since its 1987 inception date. Short term bond funds are obviously not all the same -- I should have clarified that I was referring to the more boring, routine lower risk bond funds.

But true, who's to say that tomorrow some scandal won't surface, and a CD would be safer.

 

[summer2007]

Harley

I think the real idea behind the CD ladder is that longer term CD's usually have higher yields but you could just buy some 5 year and 4 year and 3 year and keep some money liquid or whatever.

OAG was the one who taught me a lot about CD's I wish he was still here. I know there are a few objectionable people here but there are on every forum...I wish he would have stayed.

Also check the early withdrawal penalties on CD's before you buy them. I looked around my local area and I got a big range of penalties. The best was 6 months and the worst....well! The worst is really whatever the bank wants it to be and some banks use strange formulas and really stiff penalties. The penalty for some where I'm at was 20% on a 5 year CD or 2 years interest on another!! That is how bad it can get.....I don't know why anyone buys CD's with those terms but maybe they just don't check?

Jim

 

[harley]

As long as we bumped this old thread, I confess I never thought CD ladders added much. Other than a theoretic twinge less risk, I can't see their advantage over a good quality short term bond or even a short term federal bond fund. Returns seem comparable or better for the bond fund, both are stable, and the fund is liquid with checkwriting, etc. any time you wish, and no early withdrawal penalties or yearly purchasing hassle.

FDIC coverage, granted. Anything else compelling in favor of CDs?

I don't disagree wth you personally, but I'm dealing with my Mom. She's a great LBYM type, and a great saver, but she has zero knowledge of any investing techniques, and adamantly refuses to consider anything other than cash. I tried to point out that if she had invested this money over the last 25 years instead of just saving it, she'd probably be worth a couple million, even after the meltdown. But I was talking to the hand.

If you're concerned about low 5 year CD rates, maybe do a three year ladder for now. Its still much better than earning 0% in her checking and savings.

Also make sure you use different banks to keep below the FDIC limit.

Therein lies another problem. She doesn't have (or want) access to the intertubes, so she wanders around her mid-sized town looking for the best rates. She does keep below the FDIC limit, but is nowhere near getting the best rates around nationally. I'm going to ask her is she wants me to manage the CDs, shopping them and moving them around as needed. Otherwise, it's local and big national banks, about 10 to choose from, and just let them roll over. Hopefully she'll let me get involved to maximize her returns. Doing it once/year wouldn't be any imposition for me.

Also check the early withdrawal penalties on CD's before you buy them. I looked around my local area and I got a big range of penalties. The best was 6 months and the worst....well! The worst is really whatever the bank wants it to be and some banks use strange formulas and really stiff penalties. The penalty for some where I'm at was 20% on a 5 year CD or 2 years interest on another!! That is how bad it can get.....I don't know why anyone buys CD's with those terms but maybe they just don't check?

I suspect very few people even consider early withdrawal when setting up a CD. I probably wouldn't either, except in conditions like these today, with low interest rates that are liable to increase significantly over the life of a 5 year CD. I'll read the fine print, and hopefully will be able to explain it to her.

 

[ats5g]

harley,

A CD ladder is a middle of the road approach to rising or falling CD rates. If CD rates rise, you get to partake b/c you've always got a CD maturing every year. If CD rates fall, you don't get taken to the cleaners b/c you've always got CDs earning the higher past rates for a while. A CD ladder smooths out the changes in interest/income.

 

[clifp]

Therein lies another problem. She doesn't have (or want) access to the intertubes, so she wanders around her mid-sized town looking for the best rates. She does keep below the FDIC limit, but is nowhere near getting the best rates around nationally. I'm going to ask her is she wants me to manage the CDs, shopping them and moving them around as needed. Otherwise, it's local and big national banks, about 10 to choose from, and just let them roll over. Hopefully she'll let me get involved to maximize her returns. Doing it once/year wouldn't be any imposition for me.

Be careful what you wish for. I did the same thing for my mom, and the next thing you know you end up managing all of their investments. Actually I think we are both happier. I still let her roll over CDs in the local banks and she is in Rogue River Or. Pop 2,000...

BTW, board favorite PenFed is a joy to work with over the phone, and they offer the best rates 4% for 5 years 3.5% for 3 years. I think they are very accustomed to working with little old ladies.

 

[harley]

Be careful what you wish for. I did the same thing for my mom, and the next thing you know you end up managing all of their investments. Actually I think we are both happier. I still let her roll over CDs in the local banks and she is in Rogue River Or. Pop 2,000...

BTW, board favorite PenFed is a joy to work with over the phone, and they offer the best rates 4% for 5 years 3.5% for 3 years. I think they are very accustomed to working with little old ladies.

Sounds perfect, thanks! She deals with other military organizations (USAA, Tricare, etc), and always has good things to say about them. I'll try to start her phone CD hunting with them, make it a little less painful.

Actually, I wish she would let me handle things. I'd do it according to her wishes, and I suspect it would take me 1/10th as much time to do it as to work through it with her. Finances or computers, I work better hands on. I always sucked at phone support. Seems like as long as the money is "safe" and the interest checks roll in on time, she should be happy. We'll see.

 

[REWahoo]

Harley, I can't find it at the moment but seem to recall that PenFed charged no penalty for early termination of IRA CD's. Not sure if any of your mom's money is in an IRA, but thought you might want to check it out if that's the case.

 

[Nords]

Harley, I can't find it at the moment but seem to recall that PenFed charged no penalty for early termination of IRA CD's. Not sure if any of your mom's money is in an IRA, but thought you might want to check it out if that's the case.

It was either that or no penalty for terminating an IRA CD in favor of a CD paying a higher interest rate for at least the same term length.

 

[UncleHoney]

In the past year I renewed two regular CD's before they matured without penalty. One was a five year that I got in April 2008 and by June 2008 the rate had gone up about 1/2%. The other was a five year CD that matured in April this year. As I was watching rates fall I decided to renew it in January. I felt like a fool renewing for a lower rate but not as low as the rates ended up in April.

I think it all depends on your banking institution if they charge you with a penalty. My CD's are in a credit union (not PenFed). The new terms were the same as the old one, just a different rate.

 

[harley]

Mom's money is all after tax.

We used to have CDs that allowed one withdrawal before maturity. But I'm pretty sure they had a slightly lower yield.

This isn't a huge problem for me. I just want to be able to assure her that you aren't locked in at gunpoint or anything. Mostly I'd like to get her ladder going, the interest flowing, and get the ~$200K out of the savings accounts.

Thanks everyone.