CDs and CD Ladders

A savings account rate can fall next month. A certificate of deposit (CD) fixes the rate until a date you choose, in exchange for giving up easy access to the money until then. That trade is a good one for money that already has a date attached, and a poor one for money you might need tomorrow. This chapter explains how CDs work and what breaking one early really costs, when locking a rate makes sense, and how a ladder of CDs gives you a fixed rate and regular access at the same time.

How a CD works

You deposit a sum for a set term, commonly three months to five years. The bank pays a fixed rate for the whole term, quoted as an APY. At the end, the maturity date, you get the deposit and the interest back. A CD at an insured bank or credit union is a deposit like any other, insured up to $250,000 per depositor, per bank, per ownership category, counted together with your other deposits at that bank.

Three terms deserve a careful read before you open one:

• The early withdrawal penalty. Each bank sets its own, usually as a number of months of interest, often more for longer terms. If you withdraw early in the term, before that much interest has been earned, the penalty can come out of the money you deposited.
• What happens at maturity. Most banks renew a maturing CD automatically for the same term at whatever rate they then offer, after a short grace period, often seven to ten days. If you miss the window, the money is locked again, sometimes at a poor rate.
• Call features. Some CDs, mostly sold through brokerages, let the bank end the CD early. Banks do that when rates have fallen, which is exactly when you would want to keep the old rate.

Here is what the penalty means in practice on a one-year CD:

The CD earns $400 over the year. A penalty of three months' interest would take roughly a quarter of that, and a penalty of six months' interest roughly half. Breaking a CD is rarely a disaster. It does mean a CD only beats a savings account if you are fairly sure you will leave the money alone.

The penalty you pay on an early withdrawal is deductible on your federal return as an adjustment to income, even if you do not itemize. The bank reports it on the same form that reports your interest.

When locking a rate makes sense

The case for a CD rests on two things you may know and the bank does not care about.

You know when you need the money. A tax bill in April, tuition in August, a down payment in eighteen months: for money like this, the only risk is not having it on the date. A CD that matures just before the date removes rate risk and temptation together.

You want certainty about the rate. Savings rates move with the Federal Reserve. If rates fall, a CD keeps paying the old rate. If they rise, you are stuck with the lower one until maturity. Nobody reliably predicts which will happen, so the honest reason to lock a rate is that a known return is worth more to you than a possibly higher one.

The difference a locked rate makes depends on what savings rates do in the meantime. If a three-year CD pays 4.2% and savings rates drift down so that the savings account averages 3.2% over the same three years:

The CD earns $2,627 and the savings account $1,982. Had rates risen instead, the comparison would run the other way. Longer terms do not always pay more, either: when the market expects rates to fall, one-year CDs can pay more than five-year ones, as they did for much of 2023. Compare the actual rates for each term before assuming that longer is better.

Building a CD ladder

A ladder spreads money across several CDs that mature at different times, so some of it is always coming free.

The classic version uses five equal rungs. You split the money into fifths and buy CDs maturing in one, two, three, four and five years. When the one-year CD matures, you reinvest it in a new five-year CD. A year later the original two-year CD matures and goes into a new five-year CD as well. After four years, every rung is a five-year CD, yet one of them matures every year. You earn something close to the five-year rate on the whole balance while a fifth of it becomes available every twelve months.

A shorter ladder works the same way with smaller steps. Someone saving for a down payment in a year might buy CDs or Treasury bills maturing in three, six, nine and twelve months, adding to each rung as savings come in. The down payment savings calculator shows the monthly amount needed to reach the target by the date.

A ladder is not a free lunch. Money in a five-year rung is still locked for up to five years, so a ladder suits money beyond the safety reserve, not the reserve itself. And because each rung renews at the rate on its renewal date, a ladder smooths rate changes rather than escaping them. Its real value is that it removes the need to guess: you never put everything in at the top or the bottom of the rate cycle.

No-penalty CDs

A no-penalty CD fixes a rate for a term but lets you withdraw without a penalty after a short wait following the deposit, often about a week. The rate is usually lower than a regular CD of the same term and sometimes no higher than a good savings account. Many require you to withdraw the whole balance at once rather than part of it. They can make sense when you expect savings rates to fall and might still need the money: you lock today's rate and keep the exit.

Brokered CDs

A brokered CD is issued by a bank but bought through a brokerage account. A brokerage offers CDs from many banks on one screen, which makes it easy to compare rates and build a ladder in one place. Insurance still runs through the issuing bank, so you must add up your holdings bank by bank to stay under the limit.

The important difference is how you get out early. You generally cannot redeem a brokered CD with the bank. You sell it to another investor at the market price. If rates have risen since you bought, that price will be lower than what you paid, and the loss can exceed a bank's early withdrawal penalty. If rates have fallen, you may sell at a gain. Brokered CDs also tend to pay interest out to your account rather than compounding it, and some are callable. Hold them to maturity, or treat them as you would a bond.