I Use a CD Ladder. Here's Why You Should, Too

I'm a big proponent of working smarter, not harder. Which is why I look for ways to put my life on autopilot. For investing, that means buying great dividend-paying companies and setting dividends to be reinvested. For cash, it meant setting up a CD ladder, which is paying off very well right now as interest rates head higher.

Here's why you might want to do the same thing.

Take the KISS approach

When you make things overly complex you are practically asking for something to go wrong. When you make things highly manual, requiring regular human intervention, you increase the opportunity for error and neglect. Entropy, or the gradual decline into disorder, is very powerful and should never be ignored. Which is why I'm always telling myself to "keep it simple, stupid."

Image source: Getty Images.

I don't think I'm stupid, that's just the saying. But I see the last "S" in the KISS approach to life as a reminder that even I make mistakes that can be avoided. This is one reason I put three months' worth of living expenses into a savings account to provide an emergency cushion in case of an unexpected life event. I did this years ago before interest rates on bank accounts fell toward zero. At the time it was the simple way for me to ensure my family's financial security and earn some interest along the way. 

And then rates started to head toward zero and it was just dead cash, doing little to nothing other than providing a safety net. To be fair, that's an important job, and I never once thought about moving that emergency money into more risky investments (like stocks or bonds) where I could lose money. But I did make an important change by initiating a certificate-of-deposit (CD) ladder, a process that took just six transactions spread over 12 months to complete. It was worth it, and the rising interest rate environment proves that.

What is a CD ladder?

In my case, I chose to break my emergency savings into six parts, and with each part, I bought a one-year CD through my bank, which means these savings are protected by FDIC insurance. Certificates of deposit tend to have higher rates than savings and checking accounts at all times because you are locking that cash into the CD for whatever the term of the CD happens to be (one year, in my case).

I opened a new CD every two months, meaning I spent about a year thinking and executing this project. Still, the actual time spent on making this happen was very minimal. The CDs I bought are from a bank that guarantees that its CDs will be among the highest-yielding in the market and that automatically rolls over CDs when they mature at whatever the prevailing CD rates are. Basically, I thought about this one time (for a year) and I've never had to think about it again.

Chart by the author.

By breaking the maturities up, with a CD coming due every two months, I ensure I can pretty much always have access to some of the cash without too much trouble. You could set up a similar ladder by opening one CD a year over several years or buying multiple CDs all at once but with different maturities, say one-, three-, and five-year CDs. I wanted more access to the cash and I wanted to ensure that short-term changes in interest rates would show up quickly in my CD ladder.

And that's happening today. To give an idea of the change, the interest I earn each month on one of my most recent CD rollovers increased by 4.5 times! But here's the really important part: I didn't do anything to make that happen. I set it up once, years ago, and now it is on autopilot. 

Over the past year, I've read news stories about consumers rushing to take advantage of higher interest rates by pulling cash from low-yield accounts and buying higher-yielding ones, including CDs. They are making the right decision, but if that's cash that isn't going to be used for a long time (earmarked for emergency savings or an expense, like college, that may be years down the line), taking a manual approach is the hard way to solve the problem. When the situation changes again, which it will eventually, the manual approach means you have to think and act again. I won't; if rates keep going up, so too will the rates on my CD ladder.

Not perfect, but perfect for me

The bad part of this is that my CD ladder will also adjust downward if interest rates fall. But there's really no way to avoid that without locking in rates for extended periods, which I'm not willing to do (and which would mean potentially missing out on a further rise in interest rates). You can also argue that pulling cash out of a CD early generally involves penalty payments, which is true. But if I need this cash for an emergency, that will very likely be the least of my concerns. If you need it for college or some other far-out expense, you'll have to think about the maturity dates of the CDs a little more carefully. 

But to my thinking, the benefits easily outweigh the negatives because this simple approach required me to set up only six CDs and now I'm done, essentially, forever. Meanwhile, I know that the interest I'm earning on this cash will roughly keep pace with whatever is going on with interest rates more broadly. This doesn't require huge sums of money and isn't particularly difficult to do, it just means stepping back and thinking strategically about something that may seem like a short-term problem. If I can do that, anyone can.