If you are disappointed with the low interest yields offered by even the highest-yield savings and money market accounts, but you don’t want to tie your short-term cash in a riskier investment, consider certificates of deposit (CDs). CDs, however, generally carry penalties if you withdraw your cash before they mature. In other words, you invest in a CD designated with a length of time that represents when you would like your money, plus interest, back. But if you need to liquidate the CD, a bank may take away some or all of the interest that has accrued since the time of the deposit.

A certificate of deposit is considered a “deposit account” just like a savings account or money market account. You are allowed to earn interest, and if the bank enrolls in the program, your cash will be protected by the FDIC up to the limits allowed by law.

There is a way to structure your certificates of deposit in a form that reduces the risk of losing a large portion of your interest, and it is called a CD ladder. At staggered intervals, you buy CDs with staggered maturity dates until you only need to buy CDs with the longest maturity date. The result is every few months, a CD matures and you can roll the cash into a new CD or use the cash for your short-term expense needs.

The process consists of two phases. For this example, we’ll use the latest rates from Ally Bank which does not have a minimum balance requirement.

Setting up the ladder

These are the CD products and interest rates (effective November 6, 2009) we will be dealing with:

We can use this combination of maturities to create a ladder that provides us with a roll-over, or a chance to withdraw part of the cash, every three months. During Phase 1, this will require a combination, but by Phase 2, all CDs will be of the 5-year maturity, which usually offers the highest interest rates. Remember that five years is as long as you want to go; any money that you won’t need for more than five years can stand to be in a slightly riskier investment.

Assume that we have $10,000 that we’d like to begin rolling into certificates of deposit. Since the longest we want to go is five years, we can split this evenly over time at $2,000 per year. Our shortest maturity is three months, so we can tackle this in terms of $500 a quarter.

In the first phase, start on day zero by buying CDs in the following pattern:

• $500 in the 3 month CD
• $500 in the 6 month CD
• $500 in the 9 month CD
• $2,000 in the 12 month CD
• $2,000 in the 2 year CD
• $2,000 in the 3 year CD
• $2,000 in the 4 year CD
• $500 in the 5 year CD

At the end of the each of the first three quarters, withdraw each quarter’s $500 plus interest and use the funds to buy new 5 year CDs. For the sake of the example, we’ll withdraw the interest and place it in another bank account to use as income. To make more of your money, “reinvest” your interest each quarter.

Watch out for automatic renewal. At Ally Bank, CDs are automatically renewed for the same duration when they mature. During this stage, you will need to be proactive to withdraw the funds at maturity and use them to buy the next appropriate CD.

After one year of doing the above, this is what we have:

• $2,000 maturing today (original 12 month CD)
• $2,000 maturing in one year (original 2 year CD)
• $2,000 maturing in two years
• $2,000 maturing in three years
• $500 maturing in four years
• $500 maturing in four years, three months
• $500 maturing in four years, six months
• $500 maturing in four years, nine months

With the $2,000 maturing today, buy:

• $500 in the 3 month CD
• $500 in the 6 month CD
• $500 in the 9 month CD
• $500 in the 5 year CD

Do the same with the $2,000 that matures each year until you have 20 CDs, each maturing every quarter for the next five years. Once this process is complete, you can allow the automatic renewals to take effect except for when you need to withdraw your money.

Drawbacks of the CD ladder

You may notice that, as long as rates for long-term CDs remain higher than short-term CDs as they do most of the time, this method results in earning less than simply investing your entire $10,000 in a 5 year CD. But the CD ladder provides you some protection against losing interest if you need to withdraw your funds early. At Ally Bank, the penalty is not significant. This bank will charge you the amount of three months’ interest if you withdraw a CD with a maturity of 12 months or less or 6 months’ interest if you withdraw a CD with a maturity of longer than 12 months.

Another possibility to consider is that you might earn more interest in a high-yield savings account than you would in a short term CD. Ally Bank’s Online Savings Account earns 1.55% right now, making it more attractive than the 3, 6, and 9 month CDs. When this is the case, use a specially designated savings account rather than the short term CDs.

We could have made this process easier by setting up a ladder that results in a turnover of $2,000 once a year rather than $5,000 every quarter. This method allows you to decrease the possibility of losing interest because you will always be able to access a portion of your investment within three months. In combination with a savings account, which is liquid at all times, you can earn consistently higher interest rates with less risk than using five-year CDs that mature only once a year.

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