Which of the following accurately describes the certificate of deposit investment strategy known as laddering? a) Redeeming a certificate of deposit and reinvesting in a new certificate when interest rates increase b) Purchasing multiple certificates of deposit (CDs), rather than just one, with equally spaced terms of maturity c) Purchasing certificates in progressively increasing deposit amounts d) Immediately purchasing another certificate as one certificate matures
The correct answer and explanation is:
Correct Answer:
b) Purchasing multiple certificates of deposit (CDs), rather than just one, with equally spaced terms of maturity
Explanation (Approx. 300 Words):
CD laddering is a conservative and strategic investment approach that involves dividing an investment into multiple certificates of deposit (CDs) with staggered maturity dates. This method allows an investor to take advantage of higher long-term interest rates while also maintaining periodic access to cash without paying early withdrawal penalties.
Here’s how CD laddering works: Instead of placing all your money in a single long-term CD, you split it into several CDs with different terms—such as 1-year, 2-year, 3-year, 4-year, and 5-year CDs. As each CD matures, you have the option to either reinvest at the new (hopefully higher) interest rate or use the funds for other financial needs. This creates a steady stream of maturing CDs over time.
For example, if you invest $10,000 using a 5-year ladder, you might buy:
- $2,000 in a 1-year CD
- $2,000 in a 2-year CD
- $2,000 in a 3-year CD
- $2,000 in a 4-year CD
- $2,000 in a 5-year CD
When the 1-year CD matures, you can reinvest it into a new 5-year CD. After five years, you’ll have a CD maturing every year.
This strategy provides three key benefits:
- Liquidity: Since a portion of the investment matures periodically, funds are regularly available.
- Interest Rate Protection: You aren’t locked into one interest rate environment. As rates rise, you can reinvest at better rates.
- Risk Management: It reduces the risk of reinvesting all funds at a poor time (e.g., during low interest rates).
Thus, the laddering strategy described in option (b) is the most accurate representation.