Cash Management: CD Laddering
Effective cash management is critical for you to cover day-to-day expenses, preserve liquidity, collect interest, and ultimately, acquire assets that compound wealth. The certificate of deposit (CD) is a tool integral to cash management, as it is backed by FDIC insurance coverage. All transactions, even simply depositing cash in the bank, do introduce distinct financial risks. Conservative savers may implement CD laddering strategies to mitigate interest rate and inflationary risks.
Bank Deposits and FDIC Insurance
A certificate of deposit is effectively a loan made out to the bank. CD holders collect interest payments until the principal balance is repaid at maturity. Here, lengthier maturities typically offer higher interest rates. Be further advised that you will be charged penalties for closing out the CD before its maturity date.
The Bank profits on “the spread,” or difference between interest received and paid out on deposits. The FDIC defines certificates of deposit (CDs) alongside checking, savings, and money market deposit accounts, as deposits. Bank deposits may be categorized further, according to single, joint, corporate, government, and employee benefit and trust holdings.
As banking deposits, both CD principal and accrued interest are guaranteed by FDIC insurance. In 2008, amid the Great Recession, the Federal Government passed the Emergency Economic Stabilization Act, which temporarily increased FDIC insurance coverage limits from $100,000 to $250,000 per depositor, per bank. In 2010, the Dodd-Frank Act established the $250,000 limit as permanent. A wealthy depositor will take out multiple CDs at multiple banks – to maximize FDIC coverage.
CD Interest Rates
The Federal Reserve Act of 1913 awarded the central bank with the contradictory dual mandate of full employment and a stable price level. Fed Chair Jerome Powell has already signaled his intent to aggressively slash interest rates, with pandemic era inflation now seemingly under control. Low rates stimulate the economy – by encouraging lending, capital spending, and investing.
The federal funds rate is now 4.25% — after having been lowered by 1% over the course of one year. From here, Wall Street expects the Fed continuously lower this benchmark through subsequent meetings. Bank deposits have responded in kind, with one-year and five-year CDs now paying out 1.93% and 1.61%, respectively. Yes, the yield curve inverted post-pandemic and has yet to normalize.
Longer-dated CDs typically pay out more in interest – to compensate depositors for locking up money through lengthier time frames. We fully expect for the yield curve and CD rates to normalize in the near future, with the Fed lowering rates and inflation dissipating. The Fed, of course, will drive rates higher to slow the economy, if inflation were to return. Interest-rate risk would make existing CDs less attractive.
CD Laddering
Proper CD laddering strategy calls for you to take out CDs with different maturity dates to game the yield curve. A simple CD portfolio may include two separate one-month and one-year CDs.
The short-term CD matures each month for ready cash and liquidity to be reinvested at higher rates. Meanwhile, the long-term CD would lock in a good rate, if interest rates were to actually fall in the future. Effective cash management strategy will have you providing for living expenses, building out an emergency fund, and moving funds into productive assets for real wealth.