CD Structure and Laddering

With thoughtful cash management strategy, you can pay your bills on time and build cash reserves to purchase big-ticket items. As part of your cash management plan, you may explore certificates of deposit (CDs) to maintain a measure of liquidity and collect interest payments. Although your CD principal is guaranteed, you will be exposed to interest rate and inflation risks. To manage these risks, you will incorporate CD laddering within your financial plan.

CD Structure

A certificate of deposit is actually a loan that you make out to your bank. After lending out the money, you will collect interest until your CD principal is repaid at maturity. With CDs, you will generally earn higher interest rates if you agree to tie your money up with the bank for extended periods of time. The bank turns a profit when it invests your money for its own benefit, at a higher rate of return than your associated interest payments. The bank is therefore relying upon your certificate of deposit as a steady source of capital for it to purchase investments. As such, the bank will levy penalties that discourage you from taking early CD withdrawals before maturity.

CDs and FDIC Insurance

As of 2010, the FDIC insures $250,000 worth of bank deposits per customer, per financial institution. As a larger investor, you would then divide one lump sum into multiple CDs at different banks so that your entire balance will be insured. For example, you would divide $700,000 amongst seven $100,000 CDs at seven different banks to maximize your FDIC coverage. Alternatively, you would leave $450,000 uninsured if you simply took out one $700,000 certificate with your lump sum.

CDs and The Federal Reserve Board

The Federal Reserve Board manages the prevailing interest rate environment and economy through its monetary policy. To do so, the Fed sets a target for its federal funds rate, which is a benchmark for all interest rates. Banks lend money to each other overnight at the federal funds rate in order to meet their respective Federal Reserve requirements. For CDs, you can expect to earn a premium above the overnight federal funds rate because, again, banks offer higher interest rates to borrow money for extended periods of time. You can read "The Wall Street Journal" daily for commentary and graphs of average federal funds and CD rates. Interest rates generally rise amid a strong economy due to increased loan demand and Fed policy to counter inflation risks. The Fed drives rates higher to actually slow down the economy and price increases for goods and services.

CDs and Financial Risks

CDs are exposed to both inflation and interest rate risks. Inflation erodes the future purchasing power of your repaid CD principal and interest payments. In terms of interest rate risks, existing CDs are even less attractive when prevailing interest rate rise. Today, you may take out a 7-year CD that pays out interest at a 4-percent rate. After two years, however, 7-year CDs may offer 8-percent rates due to Federal Reserve rate increases. Returns on your old 4-percent CD would then appear to be relatively minimal.

CD Laddering

With CD laddering, you will take out multiple CDs with different maturity dates to preserve liquidity and manage the interest rate environment. To do so, you could put cash into separate one-month, one-year and three-year certificates. If interest rates were to move higher, you would roll the one-month CD into a new one-month CD every 30 days to take advantage of better rates. Alternatively, the one-month and three-year certificates of deposit would help you to lock in relatively high returns over the long term, if interest rates were to actually fall.

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