CD Ladders: Hedging Against Risk With Fixed Interest

The certificate of deposit has long been revered as a low-risk investment with a fixed income reward. It is often considered the fail safe investment of both pre and post retirees. However, a certificate of deposit, while less risky than many investments, does have its own set of risks that can be avoided with the right strategy.

What is interest rate risk?

Interest rate risk is the risk involved in any fixed-income investment that locks you in to a fixed interest rate for a set period of time. Because you are locked in to that fixed rate, you are at risk for missing out on the higher interest rates offered during your term.

Anticipating the Risk-and Protecting Yourself against It

There is an easy way to hedge against interest rate risk, and that is by creating something called a CD ladder. With a CD ladder, instead of investing all your money in one CD that is locked in for one term, you spread your money out into several different CDs with graduated maturation dates.

For instance, let's say you have $20,000 to invest in a CD. You can invest the entire $20,000 in one 5-year CD at a given rate. If CD rates increase in 12 months, you may not be able to capitalize on the increase because your early surrender fees could negate any benefit the additional interest would give you.

However, if you invest just $5k into a 5-year CD at a current rate, then invest the rest in small increments and varying maturity dates, then you will have CDs maturing throughout the years and will be able to roll that money over into new CDs at (hopefully) higher rates.

Facing a Financial Emergency with a CD Ladder

If you have a financial emergency and need to tap into your CD before it matures, then you may be charged a penalty. With a CD ladder, your CDs can be maturing often enough that you might not need to take an early withdrawal and pay a penalty when you run into financial need. Additionally, because certificate of deposit are so easy to renew, you can just roll the money over if you decide that you don't need it after it matures, and you will still be taking advantage of an improved rate you will likely consider savings accounts, certificates of deposit and money markets. Unlike CDs and savings accounts, money markets offer two different options-money market accounts and money market funds. Each offers different money market rates. Depending on which you choose, they might even have a variance between annual percentage yields and rates. While this might sound overwhelming at first glance, it is actually pretty easy to understand the difference between each money market type and rate structure.

Yolander Prinzel is a financial writer with over a decade of financial industry experience including as an underwriter, agent and director of marketing. She has written for a number of publications and websites like http://www.DiscoverBank.com, Advisor Today, and the International Travel Insurance Journal (ITIJ).

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