I remember when I was younger (back when we all rode dinosaurs everywhere, according to my kids), you could put $100 into a plain savings account and earn 5% to 6% interest on it every year. Those days are long gone – in many ways that’s a good thing, since we were also paying 17% interest on mortgages at the same time, but I certainly miss seeing my emergency fund climb every year due to compound interest. These days you’ll probably only get about a 0.25% (one-quarter of one percent) return on your money.
You could invest your emergency fund into stocks or mutual funds, in the hopes of seeing a greater return on your investment. For instance, the S&P 500 (an index based on 500 large publicly-traded companies) grew by 29.6% in 2013 – that’s way better than 0.25%, right? But wait, in 2008, it dropped 38.5%! What if you needed to tap into your emergency fund sometime during that period, as many people did?
Before we get into the technical details, I want to say one thing – I’m not necessarily advocating this method of saving/investing over anything else. Only you can decide whether you want to keep your money in cash at home, convert it to precious metals, put it into a savings account or CD, or invest in the stock market or a mutual fund. I’m merely outlining one possible option.
Typically, a CD will offer you a higher interest rate than just a typical savings account, but it does come with a catch. If you withdraw your money before your CD has matured (usually between 6 months up to 5 years), you’ll pay a penalty. For instance, if you buy a 1-year CD, and withdraw even just a portion of the money after only 6 months, you could lose 3 months of the interest you’ve earned, or all of it. Some banks may even take a part of the amount you initially deposited. For this reason, it’s important to set up your CDs in a way that will give you access to your cash, without penalty.
What Is A CD Ladder?
A CD ladder is a series of CDs (Certificates of Deposit) bought at regular intervals so that they will mature at regular intervals. This gives you regular cash-flow at predictable intervals.
How To Build A CD Ladder
First you should decide what type of CD ladder you want to create. Do you want to be have access to some portion of your money with no penalty every month, or would you be comfortable with only being able to withdraw money once every year? Don’t forget, you can always withdraw money at any time; I’m just talking about being able to withdraw it without being hit with a penalty on the interest.
Scenario 1 – A CD Ladder where you can withdraw every month
Let’s say you’re setting up an emergency fund that will cover six months of living expenses should you lose your job. You would figure out your minimum monthly expenses, and buy a CD equal to that amount on the first of each month for six months. When the seventh month rolls around, the first CD you bought will have matured – you will roll that back over into a new six month CD. You could take out the money you earned as interest, but why not just leave it in there (buying a slightly larger CD) to help offset inflation?
This way, every month you’ll have one month’s worth of cash available to you, collecting a slightly higher interest rate than if it were just sitting in a savings account.
Scenario 2 – A CD Ladder where you can withdraw every year
Once you have your short-term emergency fund covered, you may want to look at a CD ladder with longer-term CDs. The longer you let the bank hold your money, the more interest they will pay you. So in this case you’d buy a series of 5-year CDs. This is a little tricky, however; you can’t just start off buying 5-year CDs, otherwise it will be 5 years before you can touch your money without a penalty. So here you start off buying CDs of different lengths.
All at the same time, buy a 1-year CD, a 2-year CD, a 3-year CD, a 4-year CD, and a 5-year CD. Now sit back and wait a year.
Your 1-year CD has matured, so cash it in and use the money to buy a new 5-year CD. Hold on to the other 4 CDs.
Now the 2-year CD you bought has matured, so cash it in and use the money to buy a new 5-year CD. Hold on to the rest of the CDs.
And so on – as you can see, every year one of the original CDs you bought will mature, and you’ll cash it in to buy a new 5-year CD. Eventually you’ll have 5 5-year CDs, with one maturing every year.
Regardless of the type of CD ladder you create, it’s important to keep good records, and watch your calendar for when the CDs mature. Some banks will just move the money into a low-interest savings account when the CD matures – if that happens then obviously you’re losing money you could potentially earn. Other banks might move all the money into a brand-new CD for you. That’s fine if you’re doing something like scenario 1, where you keep buying CDs of the same length. But if you’re working on scenario 2, where you need to convert a 2-year CD to a 5-year CD, you don’t want your bank giving you a new 2-year term and throwing off your CD ladder.
So where do you go to open your CD ladder? Again, this is something you’ll have to decide. You could just go down to your corner bank where you have your checking account; it’s convenient, and if you need access to your money quickly, you’ll have it in just a few minutes. The drawback is the interest rate – the majority of local brick-and-mortar banks only pay about half the interest that an online bank pays. But the drawback to opening an online account is the time it takes to get your money out – they will have to either mail you a check or do an electronic funds transfer, both of which will probably take about 3-4 days.
The best thing to do is to shop around – weigh the interest rate vs. the convenience, and use a website like Bankrate to shop around for rates and terms. Be sure to look at the early withdrawal penalties as well as the rates!
Now, you shouldn’t even be thinking about this strategy if you’re carrying any kind of revolving debt (in other words, most all debt other than a mortgage or car loan). It wouldn’t make sense to be chasing after a 2% or 3% return on your money when you’re paying 15% (or more) in credit card interest at the same time! For more thoughts on this, see our post on Why Getting Out Of Debt Should Be Your Number One Prep.
Creating a CD ladder does require a bit of calculating up-front, and some on-going record keeping, but it can provide you with a safe way to grow your emergency fund, while still maintaining easy access to it.