What is laddering?

Laddering is a controlled way of investing or depositing a significant amount of money so as to avoid having it all returned at the same time. The principle of laddering is simple: to stagger the maturity dates of the associated deposits or investments so that they mature in different time periods. You can apply laddering to any type of deposit, loan, or security having a specified maturity date. In this discussion, its use is described from the viewpoint of a cash reserve. As a result, only low-risk alternatives, such as certificates of deposit and Treasury bills, are considered.

Use laddering to minimize interest rate and reinvestment risk

Interest rates rise and fall in response to many factors. Consequently, they are largely unpredictable. Whether you apply laddering to a cash reserve or use it in portfolio investing, minimizing interest-rate and reinvestment risk is one of its most important benefits.

A single large deposit or investment that matures during an interest-rate slump will leave you with two undesirable choices: you can hold the money in a low-interest savings account until rates improve or roll it over at the now low rate. However, a later rebound of interest rates can catch you locked into the prior low rate for an extended period.

Connie has a cash reserve of $30,000. Half is in a money market deposit account, and the remaining $15,000 is in three $5,000 certificates of deposit, each expiring in a different month. Last month, when interest rates were unusually low, one certificate matured, which she redeposited in another at the low rate. This month, however, rates have rebounded strongly. Consequently, this month’s rollover will give her the new high rate. By laddering maturity dates, Connie will earn the average rate over an extended period.

Use laddering to manage cash availability

Once you have adequate liquid funds to cover living expenses in the event of an emergency (see the 3-6 months rule), you may choose to begin investing in low-risk savings vehicles (e.g., certificates of deposit, U.S. Treasury bills) that bear higher interest. When these investments equal two or more months of additional living expenses, use laddering to assure that the funds will become available without penalty and as needed to replace lost income.

In the preceding example, Connie’s certificates of deposit mature in different months, giving her the opportunity to spend the respective cash during a financial crisis. If she had deposited the entire $15,000 in a single certificate, she could find herself without available cash and a certificate that doesn’t mature for a few months. While she could withdraw that money, she would probably be hit with a substantial penalty that can be avoided by laddering the maturity dates of her CDs.

Applying laddering to a cash reserve

Applying laddering to building and maintaining the cash reserve is a three-step process. First, determine the appropriate timing. Second, plan the ladder itself and implement it by depositing the funds. Finally, maintain the ladder by rolling over individual deposits when they mature. Automatic rollover programs facilitate this process.

• Use appropriate timing for a cash reserve ladder–Because the first three months of living expenses are covered by readily accessible savings, you can use term deposits that expire or mature after that time. Your objective is to obtain maturity dates that will arrive monthly or bimonthly thereafter. This will assure their availability to replace lost income at the end of three months.
• Plan the ladder and deposit funds accordingly–Begin by dividing the amount you plan to ladder by the average of routine monthly living expenses. This provides the approximate amount to deposit for each maturity date. The first maturity date should be any date just prior to when the funds might first be needed, typically in about three months. Thereafter, add one month for each additional deposit on the ladder.

Hal and Jane are setting up their cash reserve with $15,000 more than their three-month living expense equivalent. Dividing this amount by their average monthly expense total of $5,000 suggests they obtain certificates having three different dates of maturity (specifically three, four, and five months from now). This will make the first sum available near the start of the fourth month and additional sums available in each of the two succeeding months.

• Maintain the ladder on an ongoing basis by promptly redepositing funds (rolling over the funds). Keep the ladder intact by promptly redepositing each maturing deposit for a new term. The new rollover term for all deposits should be the number of months of expenses held in the first tier of the cash reserve for immediate access. Usually this is three or four months.

The following table illustrates laddering at work. First, let’s assume that three months of expenses are always readily available (represented by the shaded boxes). To establish a cash reserve on January 1, you purchase three CDs that mature in April, May, and June respectively. When CD #1 matures in April, you roll it over into a new three-month CD maturing in July. Similarly, when CD #2 matures in May, you also roll it over into a new three-month CD maturing in August, and so forth.

Automatic rollover option can ease the maintenance process but ignores interest rate changes

Most financial institutions that offer certificates of deposit (CDs) and similar investment alternatives also offer automatic reinvestment plans. Banks, for example, will usually offer to roll over CDs at the prevailing interest rate on the day they mature. This eliminates the repetitive need to instruct the bank every month to roll over a maturing CD for another having the same time period.

While automatic reinvestment plans eliminate the repetitive hassle of requesting CD rollovers, they also mean you get whatever the prevailing rate happens to be at the time. To cope with this problem, you can use the automatic plan but occasionally check the current rates. If rates begin to fall, you should see if better rates are available elsewhere.

If you purchase multiple CDs at the same time with the intent of staggering maturity dates, the terms of these CDs will be different. However, when they mature, each should be rolled over into a new CD with the same term (e.g., three months or six months). This will assure that their maturity dates continue to be staggered and that they never mature in the same month.