Yellow's Green

The Adventures of Money Blog.

Thursday, June 15, 2006

CD Ladders and Safety Nets

We built up our ~7 month safety net pretty quickly once we put our minds to it. We also remember to factor in what it would need to be should our living situation change.

I just compared our monthly spending with the national average using one of Bankrate's calculators. We are well below the national average in almost all spending areas, except "misc." I remembered to include phone payments and student load payment in this area - so I wonder how that really does compare to the national average. Anyway, as I suspected, we are superiorly frugal: about half the national average for my age group. (We're at $935 according the their calculator, and average is $1886.)

We've done the math, and our monthly Must-Haves are actually a little higher at $1,017. We have $7,000 sitting in a money market account for a rainy day. While researching the best place to park money we're saving for down payment on a home (or something similar, like building onto this one) I came across the concept of CD laddering. This may be "duh" to you, but it's new to me, so I feel like explaining.

CDs, or Certificate of Deposits, are great if you want an exceptionally safe, short-term investment that you can do without touching at all for a given amount of time. Of course, as with most SAVINGS options, there are penalties if you touch it too soon (like losing all the interest you would have earned, or even paying back interest you would have earned but hadn't yet). They do, however, earn higher yields than Money Market accounts.

CD laddering is sorta the CD version of dollar cost averaging. Dollar-cost-averaging is when you make small installments, instead of large lump sums, into stocks or mutual funds because you never know if the market will go up or down. When it's down, you get more for your money. When it's up, you're still putting money in, and it will be that much better if it keeps rising. The same holds true for interest rates on CDs. They could go up, or down - but you almost always get better deals when you buy longer terms. So what you do is buy several CDs for different terms (term is the length of time you can't touch them).

Let's say you invest $1,000 each in a 3 month CD at 4.88%, a 6 month CD at 5.12%, and a 9 month CD at 5.12%. (These are the current rates at GMAC, one of the best rates you can find as of today's CD ratings on Bankrate.) In three months, you get your first CD back, and it's now worth $1,012. Now, you can take that money and put it back into a 9 month CD - and for fun let's pretend the 9 month interest rate has gone up to 5.25%, now it will be worth $1,053 at the end of its term. When the 6 month CD is up, you do the same thing. Now, every three months, you can purchase a 9 month CD, the highest earning "rung" on your "CD Ladder."

You can find CDs with terms as short as 1 month (though, they won't have a very good yield at all) and as long as 5 years (which will give you the best rates). If you're looking at investing money for longer than five years, you should probably look into other options besides CDs.

So I'm thinking... with $7,000 saved for emergency use over about 7 months, we would get a budget of $1,000 a month. We don't need to be able to touch all $7,000 in month one! Why don't I build a CD ladder, even if it's small like in the above example. When I compared rates, the 1 month CDs I could find are currently earning less than our Money Market account, so that doesn't make sense to do. But a 3 month CD does earn more, and I wouldn't want the hassle of buying a new CD every month anyway. So if I keep $3000 in the Money Market account for easy accessibility, and then $3000 in a 3 month CD, and $3000 in a 6 month CD - I'll have my little CD mini-ladder earning me even more "free money" than I would with all of it sitting in the Market. Trouble is, I have to come up with $2000 more before doing this would make sense.

We have about $1,000 sitting and waiting to see if we'll need it to pay for Jasper's birth. If insurance comes through like its supposed to (it's been 3+ months now), I could use that. I could also take some from our travel budget. Or just wait until we've saved it up.

Alternately, I could put about $1,000 each in a 3, 6, and 9 month CD. The trouble with that idea, though, is that we'd end up short in case of an emergency - leaving only $2,000 available in months 4-6.

Sorry, this has turned into an exceptionally long post. But, through writing this all out, I've decided what to do, so please be forgiving. (I'm usually long winded, so obviously if you're still reading, you are forgiving!)

I will keep $4000 in the market account and purchase just a 3 month CD with the other $3000. In three months, I'll know if that $1000 is available, and possibly have another $1000 saved. If that happens - I can add rung two to my ladder. If not, I'll at least have earned a bit more interest on that $3,000.


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