Thursday, September 6, 2007

Laddering Your Savings

When you have a certain amount of money saved and you want to start venturing out to the land of higher interest rates, consider laddering CDs. No, not your music collection pre-ipod, but Certificates of Deposit from a bank.

This means that you would take out CDs that come to maturity over different time frames, let's say 6 months, 9 months and 1 year. When the 6 month CD matures, you put it into a one year CD. Essentially, you are rotating money out of the maturing CDs and bumping them up into longest maturity date you feel comfortable with. In the previous example, eventually every three months a one year CD would come due.

There is no time frame that is best, it is all what works for you. Small investors should not be locked in longer than one year, but that's just my personal opinion. Most articles on laddering, including the one linked to this post's title, deal with 1 to 5 year CDs. That's not such a great plan for the working artist just starting to put their financial plan in order. The length of CD maturity may be very different, but the premise is exactly the same. In the end, you need to find out what makes you freak and what makes you fine. If it would freak you out to pour your life savings of a few thousand into CDs (as it should) and have your money locked in for six months at a time initially, then only put a small amount in. Many CDs have no minimums. You could start with a hundred bucks and call it a day, just dip your toe in and every few months buy another one with more money.

Laddering protects you in two important ways. It prevents you from having all of your money locked in an interest rate at once, and it prevents you from being stranded from all your money at once. Interest rates change all the time. For example, because interest rates change, I personally don't go higher than 9 months, but it is perfectly fine to do 12 month CDs, it's all what you are most comfortable with. Stocks aren't comforting, your savings should be.

If you ladder your CDs you are spreading the risk around. Of course, the risk is still there. Two months after you put your money in a 6 month CD the rate might go up, but if you are investing in a CD every few months, the risk will be minimized. It works is the reverse, unfortunately. The interest rate goes down and you are set to buy another CD. But by spreading the risk around, investing like clockwork despite the rate changes, you are dollar cost averaging. It's a fancy pants term for the plain fact that if you buy four things at different prices, you get an average cost. Typically, that average cost is higher than simply doing nothing or getting Nostradamus on the interest rate and just happening to choose the time when the rate is highest. The reward for the risk is that you have an FDIC insured (up to $100,000) investment that pays a higher interest rate than your savings account.

Online banks, again, almost always give the highest rates. The exception is a bank's promotional rate. "ING's 9 month rate is 5.25%, Emigrant Direct's 6 month rate is 5.10%, IndyMacs 9 month rate is 5.21% and HSBC's 9 month rate is 5.10%. It is probably easiest if you use the same bank that you have your online savings account with, but certainly search around for other rates. If you choose to ladder your CDs with a bank other than your online savings bank, just make sure you do all the CD laddering with one bank. Also, most banks will require you to have some sort of acccount with them in order to invest in their CDs. For a few fractions of a percentage point up or down, I stick with my online savings bank. Laddering CDs, unlike investing in stocks, should be easy as all get out.

Georgia O'Keeffe, "Ladder to the Moon" 1958. Oil on canvas 101.6/76.2 cm. New York, Collection Emily Fisher Landau


SavingDiva said...

I'm too lazy to deal with CDs (and I don't have enough of a cash cushion) I just deal with online savings accounts for my cash.

PiggyBankBlues said...

you're right on the money, online savings accounts are definitely the way to go when you're building a cash cusion!

laddering CDs is more a way to invest some of your cash cushion, but in no way should it deplete it. and if it's not easy, then it's not worth it. there's enough harder stuff out there that is worth it (ie stocks).