CD Ladders: Hedging Against Risk with Fixed Interest
The certificate of deposit has long been revered as a low-risk investment with a fixed income reward. It is often considered the failsafe investment of both pre and post retirees. However, a certificate of deposit, while less risky than many investments, does have its own set of risks that can be avoided with the right strategy.
What is interest rate risk?
Interest rate risk is the risk involved in any fixed-income investment that locks you in to a fixed interest rate for a set period of time. Because you are locked in to that fixed rate, you are at risk for missing out on the higher interest rates offered during your term.
Anticipating the Riskâand Protecting Yourself against It
There is an easy way to hedge against interest rate risk, and that is by creating something called a CD ladder. With a CD ladder, instead of investing all your money in one CD that is locked in for one term, you spread your money out into several different CDs with graduated maturation dates.
For instance, letâs say you have $ 20,000 to invest in a CD. You can invest the entire $ 20,000 in one 5-year CD at a given rate. If CD rates increase in 12 months, you may not be able to capitalize on the increase because your early surrender fees could negate any benefit the additional interest would give you.
However, if you invest just $ 5k into a 5-year CD at a current rate, then invest the rest in small increments and varying maturity dates, then you will have CDs maturing throughout the years and will be able to roll that money over into new CDs at (hopefully) higher rates.
Facing a Financial Emergency with a CD Ladder
If you have a financial emergency and need to tap into your CD before it matures, then you may be charged a penalty.But for the pleasure of locking your money up for 5 years, you could earn 1.23% more than a 1-year (2.57% annually over five years). The National Average for a five year Certificate of Deposit (as of the date this article was published) is only 1.47% annually. That is not a lot of extra interest for the privilege of locking your money away for four extra years. If interest rates rise sooner rather than later, you would not want to be locked into a long term agreement with a bank earning low interest rates when rates are rising. With a CD ladder, your CDs can be maturing often enough that you might not need to take an early withdrawal and pay a penalty when you run into financial need. Additionally, because http://www.discoverbank.com/cd.html/ are so easy to renew, you can just roll the money over if you decide that you donât need it after it matures, and you will still be taking advantage of an improved rate.
âYolander Prinzel is a financial writer with over a decade of financial industry experience including as an underwriter, agent and director of marketing. She has written for a number of publications and websites like Discover Bank, Advisor Today, and the International Travel Insurance Journal (ITIJ).â