Certificates of deposit and ladders

In short

A friend of mine kept a coffee can of cash on a shelf, and he never could say what it was earning. If you are holding savings you will not touch for a while, a certificate of deposit may fit. A CD is a deal with a bank. You lend the bank money for a set time, and the bank pays a fixed rate. Check the rate, the term, and the penalty for pulling money out early. Ask whether the bank is covered by the FDIC or the credit union by the NCUA. Then think about a ladder, which means several CDs that come due at different times. Simple enough.

The whole of it

What it is

I once watched my neighbor lock his lawn mower in the shed all winter, and it ran fine come spring. A CD works a bit like that for your cash. You hand it over for a season, and it waits for you.

Here is the plain meaning. A certificate of deposit is a savings product from a bank or credit union. You deposit a set amount for a set term, such as six months, one year, or five years. The bank agrees to pay a stated rate for that whole term. When the term ends, the CD has matured, and you can take your money and the interest.

A ladder is not a different product. It is a way of using several CDs at once. Picture a real ladder with rungs at different heights. Each CD is a rung, and each one comes due at a different time. That way, some cash frees up every so often.

How it works

If you have ever signed a car loan, you know the shape of it, only turned around. This time you are the lender, and the bank is the borrower.

You open a CD and fund it. The rate is set on day one. If the bank offers 4 percent for one year, that is what the CD pays for that year, even if rates around town drop next month. It also will not rise if rates climb. That steadiness is what many people like about it.

Then comes the catch. Pulling money out before the term ends usually brings an early withdrawal penalty. Banks often charge a set number of months of interest. Each bank writes its own rule, so the disclosure the bank hands you is the place to look. The penalty can eat into your interest, and in some cases a piece of your starting deposit.

At maturity, most banks give you a short window, often called a grace period, to act. You can cash out, move the money, or let it renew. If you say nothing, many banks roll the CD into a new one at whatever rate they offer that day. That surprises people. Mark the date on your calendar.

Now the ladder. Say you have $12,000. Instead of one big CD, you split it into four pieces of $3,000. You put one piece in a one year CD, one in a two year, one in a three year, and one in a four year. When the one year CD matures, you can spend the cash or buy a new four year CD with it. Over time, one CD comes due each year, and each new one is the longest term. You keep a steady stream of cash coming free, and you do not lock everything away at one rate.

The numbers, and where to find yours

Plenty of folks ask me where the rules come from, and I like that question. Good habit.

Deposit insurance is the big one. The FDIC insures deposits at member banks, and the NCUA insures deposits at federal credit unions. The standard coverage limit is the current figure, which the official source publishes each year per depositor, per insured bank, per ownership category. You can check any bank at the FDIC's BankFind tool and any credit union at the NCUA's Share Insurance Estimator. Both are free, and both are on the agencies' own websites.

The rate on a CD is quoted two ways. The interest rate is the stated rate. The annual percentage yield, or APY, shows what you earn in a year once interest compounds, which means interest earns its own interest. The APY is the fairer number to compare. Banks must disclose it under the Truth in Savings rules, which the Consumer Financial Protection Bureau explains on its website.

Interest on a CD is taxable income in the year it is credited, even if you leave it in the CD. The IRS explains how interest income is reported on its own pages, and the bank sends a Form 1099 INT when interest is high enough. Your own rate, term, and penalty are on the bank's account disclosure. Read that page before you sign.

A worked example

Let me tell you about a woman I will call Marlene. She is a school bus driver who saved $12,000 for a roof repair she expects in about three years. She did not want to gamble it, and she did not want it sitting idle.

She split it into four equal parts. Her math was easy. $12,000 divided by 4 is $3,000 per CD. She opened four CDs at one bank, with terms of one, two, three, and four years.

Say the one year CD pays 4 percent. Her interest after one year is $3,000 times 0.04, which is $120. Say the two year CD pays 4.2 percent. After one year, that CD earns $3,000 times 0.042, which is $126. These rates are made up for the story, and real rates change every day.

At the end of year one, her first CD matures with $3,000 plus $120, or $3,120. She does not need the cash yet, so she buys a new four year CD with that $3,120. Now she has four CDs again, and they come due in years one, two, three, and four from that point. One of them is always about a year from freeing up.

The roof gets done in year three. One CD matures that very year, and she cashes it without a penalty. The others keep working. She did not have to break a CD or pay anything early. That is the quiet gift of a ladder.

Where it goes wrong

I would be a poor porch friend if I only told you the sunny parts.

The first trouble is the early withdrawal penalty. Say a bank charges six months of interest, and you break a $3,000 CD paying 4 percent. Six months of interest is about $3,000 times 0.04 divided by 2, which is $60. That is small here, but on a young CD, a penalty can reach past the interest you have earned so far. Check the bank's own terms.

The second trouble is the auto renewal. A CD that rolls over at a poor rate can sit for another full term before you notice. The fix is a calendar reminder a week before the date.

Third, inflation. If prices rise faster than your CD pays, your cash buys a bit less later. The CD did its job, but the dollars shrank. Fourth, rates can climb after you lock in. A fixed rate cuts both ways.

Fifth, some CDs are callable. That means the bank may end the CD early and hand your money back, usually when rates have fallen. The disclosure says whether a CD is callable.

Last, mind the insurance limit. A person holding more than the covered amount at one bank has some money outside the insurance. Spreading it across banks is one way people handle that.

Questions to answer before you leave this page

When will you actually need this money, and is the term shorter than that date? Does the bank carry FDIC insurance, or does the credit union carry NCUA insurance, and have you checked it on the agency's own tool? What is the APY, and what is the early withdrawal penalty, in months of interest? Is the CD callable, and does it renew on its own? How many rungs would suit your needs, and what would each one cost you to open? Have you put the maturity dates on your calendar, with a reminder a week ahead? And have you thought about the tax on the interest, which the bank will report to the IRS?