Investment Guide

Term deposit laddering explained

It’s never a bad time to look for ways to maximise your savings. Term deposit laddering can be a smart investment strategy that allows you to get the most out of your term investments.

In this guide, we explain how term deposit laddering works, the pros and cons associated with this investment strategy, and how you can get started with laddering. By understanding laddering, you can decide if it is the right kind of investment strategy for your financial goals.

What is term deposit laddering?

Laddering is a strategy that involves spreading your investment across several term deposits with different maturity dates. Imagine a ladder – each rung represents a term investment, with a set amount maturing at a specific time.

How does laddering work?

Say you have $12,000 to invest. You could choose a 2-year term deposit and lock in a current rate, but what if interest rates rise in a year? With laddering, you could divide your money into four-term investments:

$4,000 in a 6-month term deposit
$4,000 in a 1-year term deposit
$4,000 in a 2-year term deposit

As each term deposit matures, you have the flexibility to decide if you want to reinvest your money into a new term deposit (with the longest maturity) or use your money for something else. By using a laddering strategy, you can manage interest rate risk by having regular access to a portion of your money, allowing for potential reinvestment at different interest rates.

Is it a good strategy?

Advantages of laddering

The key advantage of laddering is that it provides a balance between access to funds and potentially higher interest rates for longer-term investments. A portion of your money becomes available regularly, providing a potential emergency fund or income stream if needed. And, by laddering you reduce the risk of being stuck with a low interest rate for the entire investment period while still benefiting from the potentially higher interest rates associated with a longer-term investment.

Disadvantages of laddering

However, like any investment strategy, laddering also has some drawbacks.

Interest rate risk: If interest rates fall, shorter-term deposits may face reinvestment at a lower interest rate. However, if interest rates rise, longer-term deposits may be locked in at a lower interest rate.
Inflation risk: Interest rates might not keep up with inflation. If inflation rates exceed returns on longer-term deposits the funds' purchasing power may decrease over time.
Money locked in: Early withdrawal penalties may apply if you need to break a term deposit.

How to start laddering

When it comes to laddering, careful planning and consideration of your financial goals, risk tolerance and investment timeframes are required. Here are some steps to help you get started:

Define your goals and timeframes: Are you saving for a short-term expense or a long-term goal like retirement? Knowing your goals can help determine your ideal term deposit maturity dates.
Assess your risk tolerance and liquidity needs: Determine how comfortable you are with having money locked away across term investments and ensure your strategy allows for access to funds when needed.
Shop around for rates: Compare interest rates offered by different banks and financial institutions.
Choose your ladder length: How many term deposits do you want to manage? Consider the level of flexibility and effort involved.
Get expert help: If you’re unsure about where to start, consult a Financial Adviser for advice tailored to your situation.

Frequently asked questions

What is a Fixed Deposit (FD) laddering strategy?

Like a term deposit laddering strategy, Fixed Deposit (FD) laddering is an investment strategy where you divide your money into multiple fixed deposits with varying maturity dates. Instead of putting all your money into one long-term FD, you create a "ladder" with several "rungs" (individual FDs). Each rung has a different maturity period, with some maturing sooner and others later.

This approach aims to balance earning good returns and maintaining access to your funds.

How can FD laddering maximise your investment benefits?

FD laddering can maximise your investment benefits in several ways:

Capitalise on potential interest rate increases: By having multiple FDs with different maturity dates, you avoid locking your entire investment into a single interest rate. When interest rates rise, some of your FDs will mature soon, allowing you to reinvest them at the higher rates. This may help you capture better returns over time.
Reduced interest rate risk: You spread your investment across various terms, reducing the risk of getting stuck with a low interest rate for a long period. Even if rates fall, only a portion of your money is reinvested at the lower rate.
Improved liquidity: Unlike a single long-term FD, laddering offers regular access to your funds. As each FD matures periodically, you have the flexibility to withdraw the money or reinvest it. This provides a buffer for unexpected needs without penalty charges for early withdrawal.
Potential for compounding: When a shorter-term FD matures, you can reinvest the principal amount along with the accrued interest. This allows you to benefit from compounding, where your interest earns interest over time, potentially increasing your overall returns.

While FD laddering offers these benefits, it's important to remember that it might not guarantee the absolute highest return. Some of your money will be in lower-interest shorter-term FDs. However, it provides a strategic way to balance potential returns with flexibility and reduced risk.

What is the 1, 2, 3 rule of FD?

There isn't a set "1, 2, 3 rule" for Fixed Deposits (FDs). It simply refers to the principles of an FD laddering strategy. For instance, dividing your investment into three FDs with maturities of 1 year, 2 years, and 3 years. As each FD matures, you can reinvest it for a longer term (say, 3 years again) to potentially benefit from higher interest rates for longer deposits. This creates an ongoing cycle of maturing funds and reinvestments.