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CD Ladder Strategies for Savings

Posted in Money on January 4th, 2017

Savings is probably the first step in your financial journey. Many people offer advice on ways to save money for emergencies. But, where should you keep the money? Interest rates are so low, inflation just eats up whatever you make. Also, you will still need to pay taxes on whatever you collect on interest. One of the most common recommendations is to keep emergency savings in a laddering strategy. Tim has provided several excellent alternatives and reasons why.

Emergency savings is vital to as one tries to grow wealth and financial freedom. It is always recommended by a financial advisor, but the advice varies on how much to keep and where to keep them. Generally, it is recommended to keep in accessible form, usually in a savings account. Reasons are that it is federally insured through FDIC. Also, it is more secure than keeping cash in the house. Another practical advice is to buy certificates of deposit (CD) with a laddering strategy through a financial institution.

Laddering Strategy

A basic ladder consists of purchasing different maturities in equal amounts. Here’s an example found in an online bank, but it seems like they have issues with the graphics on their interactive section. This strategy is to buy equal amounts in increments of one year maturities through five years. Ideally, the five year maturity CD will accrue larger interest than the one year maturity CD.

Source: An online bank website

Another popular strategy is to buy long-term CDs (12+ months) every couple of months. This way, one will have access to a portion of emergency savings every couple of months. The downside is that it will take some time to set up this strategy.

To immediately set up CDs to mature every couple of months, one would purchase various short-term maturities (3 months, 6 months, 9 months, 12 months) in equal amounts of emergency savings. For example, by dividing $10,000 of emergency savings into $2,500 and putting them into the four short-term CDs. With automatic renewals, this allows access to money every three months and need only to set up once.

Ideally, one would not have to access the money for about a year, the first matured CD (3 months) will then be converted to a 12 months CD. This will be done again for the 6 months and 9 months CDs. Now there are 4 CDs with 12 months maturity for higher yield, but a individual CD is maturing every three months. Now, one can set up an automatic renewal of the CDs if not needed. This is a bit more time consuming to set up, but once it is set up, one will have the safety of knowing that CDs can be accessed without penalty every three months, with a bit higher yield rates.

However, here are some reasons why I do not recommend this strategy:

  1. With interest rates so low, the interest yield on all CDs cannot beat inflation. I have seen interest yield at a little over 1%. For longer term CDs (2+ years), the interest yield may be closer to 2%. If interest rates become higher, like in the 1970’s and 1980’s (greater than 10% interest rate), it may be prudent to do some sort of CD strategy to lock in rates for longer term CDs. But, during that period, having inflation-hedged products will be more important than having cash on hand and that is not the case now.
  2. Early withdrawal from CDs incur high penalty fees. This is more than one will make on current low interest CDs.
  3. Access to your CDs is dictated by bank hours, bank regulations, and federal regulations. Though unlikely, the bank can become immediately insolvent, the terms of the CDs may change by the bank, or a government action may freeze assets held in CDs.

I am not trying to deter you from using CDs for emergency savings. There are numerous ways one can implement to suit one’s needs. If CDs are within your comfort level, many on reddit (r/personalfinance) have recommended and used the strategy successfully.

Alternatives to CDs

Here on FinTekNeeks, we consult our clients to divide up savings into various assets. One of the key reasons to save is to hedge against inflation. Yes we having been harping on gold and silver. With gold and silver prices declining in the last year, I am hesitant in recommending them. However, it should represent a small portion of savings, not all of the emergency savings. Again, physical metals tend to be a hedge against inflationary central bank currency.

Another key reason to save is to facilitate growth in the economy. There are many parables about money in a great book called, “The Richest Man in Babylon” by George S. Clason. One parable talks about lending money. I perceive that the lesson in the parable is about not hoarding money, but lending to help others grow, while receiving a return on the money lent. This way, the economy gets better while the money works for you. It is not about loaning out money with high interest rates, but using the money to help build businesses and entrepreneurs. In some states, peer-to-peer lending is allowed (crowdfunded loans). There are numerous online platforms where you can lend people money for a monthly repayment, where you are acting like a bank collecting interest. However, risk is distributed by only funding a portion of the requested loan and others join in to fully fund the loan request. Also, governments have passed regulations where you can start to invest directly in companies raising funds through stock offerings. Before, this was allowed for high net worth individuals, hedge funds, and venture capitalists. It is a form of crowdfunding, but to a company, not a product or person. A word of caution, crowdfunding can easily be abused by fraud.

One option is to keep majority of the emergency savings in a stock brokerage account. Here are reasons why I like to keep emergency savings in a trade account.

  1. It can collect interest, if kept in cash. Interest will be very small, less than 1% APY. Make sure to set your account with the cash sweep vehicle.
  2. It is easily accessible. Within 3-5 business days, cash can be transferred through ACH (no fees) to your bank account. Within 5-7 business days, check can be sent through express delivery (fees). With a margin account, selling stock and waiting for settlement date of 3-5 days should not be an issue, as long as the margin is not being used.
  3. Stocks with high dividends can be purchased. Some stocks, e.g. energy trusts, offer more than 10% dividend yield, some that even pay out monthly. With some analysis, one can reduce risk of stock price decline. Even with paying taxes on these dividends, the yield will be way more than a CD.
  4. There are several option strategies that can be used on growth stocks. One simple strategy is a covered call strategy. For example, I like Apple, so I purchase 100 shares. Depending upon the trading plan, I would write a call option (obligated to sell) that would pay me a certain amount of premium. As long as the stock remains below the strike price, at expiration date, I would keep the stock and the premium, while the option expires worthless. Apple also pays a quarterly dividend, so that is a bonus. Another strategy is a put writing strategy. For example, I like Apple, but the price seems bit too expensive. I am willing to buy the stock if the price was a bit lower. I would write a put option (obligated to buy) near the price I want to buy the stock and collect a premium. If the stock price did not go below the strike price at the time of expiration, I would keep the premium and the option will expire worthless. I would keep on doing this collecting premiums until the stock price actually went lower than the strike price. Then the option will be exercised and I would have purchase the stock at the price I wanted. Otherwise, I will continue to collect premiums on each of the options I write until I actually buy the stock.

With Tim’s previous post on saving for retirement, we have provided you with options that you can choose that best fits you. We wish you much success and growth in the new year 2017.

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