Using Bank Certificates of Deposit
to Build a Savings Ladder
Money market fund yields have leveled off, and investors now face a possible move by the Federal Reserve to lower rates in the months ahead. Level 2 savers seeking to lock in the current yields with a portion of their accumulation funds can turn to certificates of deposit (CDs) from their local bank or credit union. As with other bank offerings, CDs require you to lend your money to your bank for a fixed rate of interest. Unlike savings accounts, however, you agree not to withdraw your money for a set period of time (the "term" of the CD) anywhere from one month to as long as five years. The longer you commit to leaving your money, the higher interest rate the bank will usually pay you. If you take it out early, however, you forfeit a part of the interest you would have earned.
When investing in a certificate of deposit, your decision is guided by your interest rate expectations. For example, if it's true that the pendulum has finished its swing to the high end of the normal range and it's reasonable to think that interest rates will begin falling over the next year, you would want to lock-in the higher rates for the foreseeable future by investing in 30-month CDs. This is called "extending" your maturities. (Banks offer CDs for as long a duration as five years, so you could extend even further than 30 months if you desire. The main distinction is that using 5-year CDs only frees up part of your money annually rather than every six months as in the example below.)
Conversely, when rates are at the low end of the range, you would likely not want to invest in the longer-term CDs if the Fed might soon embark on a program of raising interest rates. Under those circumstances, you'd want to invest instead in 6-month CDs. As they mature, you could then reinvest the proceeds in more short-term CDs at the revised, presumably higher, rate. This is called keeping your maturities "short."
The difficulty, of course, lies in knowing what rates will do over the coming year. This dilemma is known as the "interest rate" risk. One way to deal with interest-rate risk is to build a "savings ladder" of staggered maturities. Say you have $5,000 to invest. To build a savings ladder, tell your bank that you want to divide your money evenly among five $1,000 CDs with the maturities shown in the table below (yields are hypothetical). Every six months, one of your CDs will come due. When that happens, reinvest the proceeds in a new 30-month CD. Eventually, you'll have all your savings earning interest at the higher-paying 30-month CD rate, yet one-fifth of your savings will reach maturity (and be available to you) every six months. You'll still have some flexibility.
Many investors buy CDs from their local bank without shopping around. This can be a mistake. Why limit yourself to your local market if the banks are not offering CDs that are competitive with insured CDs available outside your area? Every month, we list 
some of the top-yielding insured bank CDs around the country. Or for more options, go to BankRate.com. Barron's is also a good source for this kind of information. 
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