FINANCIAL TOOL
Laddered CDs
When we’re working and earning, Certificates of Deposit may not sound all that exciting.
After all, our emergency fund needs to be liquid. And so does our fund for occasional expenses (like house repairs, car maintenance, etc.). At least, for the most part.
But like a bank, we also know with a fair degree of reasonable certainty that not ALL of our occasional expenses are going to come due all at the same time.
Banks are reasonably certain that not all of their depositors are going to come asking for full withdrawals all at once.
In the same way, we know that, while it’s possible, it’s not probable that our car will break down at the same time our roof needs replacement while we rack up a surprise medical cost and decide to take an overseas vacation all within the same quarter.
It might happen, but not likely often, if ever. If it does, that’s what the emergency fund is for. But the fund for occasional expenses can be more versatile in how we invest it.
Like a bank, we can loan out some of our reserves in the form of purchasing CDs. But the best CD rates often come with the longest lock-up period. So how do we keep enough liquidity while still capturing that higher interest rate?
Most of the time, the yield curve is upward sloping. That means, shorter duration fixed income is going to pay a lower interest rate than those with longer durations. That’s not always the case, particularly when recession appears likely, but it’s the normal state of interest rates.
With this in mind, here’s an example of laddering CDs.
Let’s say a 3-month CD is paying 4%. But a 12-month CD is paying 4.6%. We want that higher rate.
Assume we have $16,000 saved away in our “occasional expenses” fund and $20,000 saved in our emergency fund.
The emergency fund stays liquid, usually in something like a money market account.
But the occasional expenses fund can be laddered like this. Every three months, we can place $4,000 into a 12-month CD. After 12 months have passed, we now have 4 sets of $4,000 earning the one-year rate.
And $4,000 becomes liquid every three months, at which point we can reinvest back into another 12-month CD or use it if needed.
In the meantime, if an expense comes up that requires a withdrawal from savings, we can temporarily draw from the emergency fund and replenish that amount when the next CD comes up for renewal.
While this is a specific example, just think of what 4.6% on a $16,000 cash amount would mean: $736 after a 12-month period! Of course, this oversimplifies the fact that 12-month interest rates would be constantly changing with each renewal.
But $700+ easily pays for a variety of possible expenses, from car maintenance to hotel costs during vacation.
This constitutes very short-term investing. And while it may not make us rich, it can easily make an impact upon our ability to meet additional expenses during a year!