I have most of my cash in a high-yield savings account making 4.12% APY. However, in previous days when the yield curve wasn’t so flat, a technique called laddering along with certificates of deposit (CDs) was pretty popular.
For example, let’s say you had an emergency fund of $5,000. You want to keep that pretty liquid and safe, but you also don’t want it sitting there getting eaten up by inflation. So, you put $1,000 in a savings account, $1000 in a 1-Yr CD, $1000 in a 2-Yr CD, $1,000 in a 3-yr CD, and $1,000 in a 4-Yr CD. You would end up with better overall interest rate, and take an interest hit if you needed to take out more than $1,000 in a year by breaking the older CDs. Now, when the 1-Yr CD matures, you go out and buy another 4-Yr CD, keeping the ‘ladder’ intact (The old 4-Yr CD now has 3 years to go, etc). For a while, the increase in interest by doing this was not worth the loss in liquidity. Let’s check again:
I’ll use INGDirect as an example since they are OK in the interest rate department, and their CDs are very flexible since you can open them with any amount. You could make a small $600 CD ladder with their savings account and 1,2,3,4, and 5 year CD in $100 increments. There are definitely many banks with higher rates out there.
So, if you kept $5,000 in their Orange Savings Account (OSA), you’d currently get 3.40% APY, or $170 in a year.
Let’s look at if you make the following ladder with the current rates:
$1,000 OSA at 3.4% APY
$1,000 1-Yr CD at 4.2%
$1,000 2-Yr CD at 4.5%
$1,000 3-Yr CD at 4.65%
$1,000 4-Yr CD at 4.7%
$5,000 Ladder earning 4.29% APY
That’s an increase of 0.89% annual interest. Equivalently, you’d get $214.50 in a year, an increase of $44.50 or 26%. Not bad if you do have money at ING.
Remember that you are giving up liquidity by doing this. ING charges a penalty of 6 months interest for breaked a CD with a term longer than 1 year. Be aware that if you break in less than 6 months, you’ll actually be losing money! But, it may be worth it. Now I need to see if I can find a bank with consistently high rates to open a up a ladder with better rates. It would have to be all at one bank, otherwise it’d be a pain to keep track of.
You can do alot of different things with laddering – make the time increments longer, shorter, wider apart, closer apart, and so on. Many people also use this technique with marketable bonds and savings bonds.
By Jonathan Ping | Banking | 10/30/05, 9:11am