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‘Ladders’ Help You Build a Flexible Personal Finance Plan

Oct. 6, 2015
Insurance, Life Insurance
Ladders Help You Build a Flexible Personal Finance Plan
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Building a financial “ladder” means buying a series of bonds, CDs or other financial products that have different maturity dates. This way, rather than tie up all your money in a single investment for a long time, you have multiple products maturing at regular intervals. Laddering offers protection from risks related to interest rates and allows you to enjoy the higher returns of longer-term investments while still creating cash flow.

A less-well-known strategy is building a life insurance ladder. Instead of buying one large term life policy, you get life insurance quotes for two or more smaller policies of different lengths. The goal is to match coverage more closely with your family’s needs in the event of your death. This strategy can save money on premiums while providing your loved ones with just the right amount of protection.

Building a ladder requires forethought and attention, but the benefits can be well worth the extra planning.

Here’s an overview of each type of ladder.

CD ladders

  • Good for: People who value safety.
  • Don’t do it if: You don’t have time to keep track of maturing CDs and replace them.

Over the past several years, when interest rates have been extremely low, many investors have avoided locking up money in certificates of deposit, or CDs. “Bank deposits in general now are the modern equivalent of [hiding money under] mattresses,” says Chris Chen, a financial planner with Insight Financial Strategists in the Boston area.

But analysts expect the Fed to begin raising short-term interest rates in late 2015 or early 2016. Interest rates on many financial products will follow, making CDs more attractive.

Building a CD ladder takes advantage of short- and long-term CDs. Long-term CDs have higher rates, but your money is locked up for longer periods. Short-term CDs have lower rates, but you get access to the cash sooner. A CD ladder gives you higher rates with frequent access to your money. Here’s how a five-year, $5,000 CD ladder would work:

  • Buy five $1,000 CDs, with maturity dates of one, two, three, four and five years.
  • When each CD matures, reinvest the money in a five-year CD.
  • After five years, all the CDs are earning the higher rates of return, because they all have  five-year terms. But because the maturity dates are staggered, one CD matures every year. Further, when interest rates are rising, you get a better return each time you reinvest in a new CD.

Each CD makes up one rung of the ladder. The specific way you build the ladder depends on your goals. If you keep emergency savings in CDs, you’ll want short intervals between the maturity dates, such as every month or quarter, Chen says.

The downside? It takes diligence to replace a rung every time a CD matures, says Andy Tilp, a financial planner with Trillium Valley Financial Planning LLC in the Portland, Oregon, area. “This requires being mindful of where to get the best interest rates and making sure the ladder rungs are replaced on a timely basis,” he says.

Bond ladders

  • Good for: People who have significant extra money to invest.
  • Don’t do it if: You want to do all your financial planning yourself, without the help of an advisor.

A bond is a loan you make to a company, city or government. The issuer pays regular interest and, when the bond matures, repays you the face value of the bond. Yields on bonds generally increase with the length of the bond term.

Building a ladder helps you diversify a bond portfolio. For instance, rather than sinking $100,000 into one bond, you could spread the risk by investing $10,000 each in 10 bonds. Like a CD ladder, a bond ladder gives you more access to cash as the bonds mature on a regular schedule. In addition, bonds make regular interest payments, called coupon payments. Multiple bonds with different coupon payment dates can provide steady income, an attractive benefit for retired people.

However, you shouldn’t think about building a bond ladder unless you have enough money to diversify investments in stocks and bonds.

“Most younger investors don’t have $10,000 sitting around,” says Mathew Dahlberg, a financial planner and owner of Main Street Investments in Kansas City, Missouri. Even 10 grand would be light for this approach. He usually doesn’t advise building a bond ladder with less than $100,000.

Work with a financial advisor to build a bond ladder. Bonds are hard for consumers to buy on their own, and fees are embedded in the price, Dahlberg says. A good advisor will look at similar trades and find decent prices. Once the ladder is built, an advisor can stay on top of it.

“It can get complicated,” Dahlberg says. “With 10 different bonds, you could have 20 coupon payments coming in a year.”

If you want to diversify bond investments but don’t have enough for a ladder, Dahlberg recommends investing in a bond mutual fund, which can include investments in thousands of bonds.

Term life insurance ladders

  • Good for: People who need life insurance and have a variety of financial obligations.
  • Don’t do it if: You can’t predict the timing of your family’s future financial needs.

Term life insurance covers you for a certain period, typically five, 10, 15, 20 or 30 years. Most people buy term life insurance to replace their income for their family in case they die. The family can use the money to pay for household expenses, the mortgage, the kids’ college educations and other obligations.

To figure out how much life insurance you need, add up the financial obligations over the period you want covered and subtract the liquid assets that would be available to the family. You could buy one long term life insurance policy to cover the entire amount. For example, a 35-year-old might buy a 30-year policy to cover the mortgage, the income from his or her working years and the kids’ college costs.

However, a family’s needs can diminish over time. “Furthermore, as a family’s asset base grows, the need for life insurance typically is reduced,” Tilp says.

Instead of buying one policy, you could buy two or three. Say, for instance, you want coverage to replace income over 30 years and pay for college for your two kids. The ladder could look like this:

  • A 30-year policy to replace income.
  • A 20-year policy to cover college expenses.
  • A 10-year policy to cover the initial years when your young family is just starting to build savings.

The plan should include a timeline of financial need along with projected asset growth, Tilp says. Then you can decide the length and amount of term life policies.

» COMPARE: NerdWallet’s life insurance comparison tool

Chen says term life insurance ladders are sometimes an attractive option for people who must buy life insurance as part of divorce settlements. Laddering matches needs more precisely than one policy can, a plus for some divorcing couples, Chen says.

But this strategy isn’t for you if you can’t foresee the timing of financial needs.

“It requires that you put together a long-range plan, which is a good idea anyway, and then apply the term policies as needed,” Tilp says.

It can be less expensive to buy two or three smaller policies for different years of coverage than buying one large policy. The only way to find out is to get quotes. NerdWallet’s life insurance comparison tool can help you determine how much coverage you need and compare prices.

Barbara Marquand is a staff writer at NerdWallet, a personal finance website. Email: [email protected]. Twitter: @barbaramarquand.

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