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The Secret of Laddering

How can you get the best returns at the bank? Mary Holm says laddering term deposits should give you a better return in the long run.

5 July 2022

Many New Zealanders have money in the bank in term deposits.

A term deposit is where you lock your money away with a bank for a set time and get a fixed interest rate.

You can’t get your money out until the end of the term, but you can be certain just how much interest you’ll be paid every year, and for how long. Even if interest rates drop, you’ll still get the same amount.

Who uses term deposits?

Some people have just a few hundred dollars in term deposits – for emergencies or when the credit card bill is higher than usual.

Others have hundreds of thousands of dollars sitting in term deposits, perhaps the proceeds from a house sale waiting to be reinvested in a new property.

But for many, it’s a safe place to leave their retirement savings – either before or during retirement.

These people have probably heard the message that they should take a bit more risk with at least some of that money, because higher risk brings higher returns on average.

But they like the security of holding their money in the bank.

Or they might, indeed, have their longer-term money in riskier investments, but wisely keep their short-term spending money in term deposits.

“Interest rates are too low!”

A common complaint in seminars I run is that term deposit interest rates are too low.

Until the last year or so, I’ve responded by showing a graph of deposit rates and inflation.

“The interest you get might seem low, but at least it’s considerably higher than the Consumer Price Index,” I would say.

“Look at what happened back in the 1970s and early 80s. Interest rates were in the teens. Wow! But inflation was even higher.

“You put $100 in the bank in January and withdrew $116 the following December. But that $116 would buy you less for Christmas than your $100 bought at the start of the year!

“At least now your term deposit money buys more when you withdraw it. Stop moaning!”

But I can’t say that any more.

While term deposit interest rates are rising, inflation has zoomed up and, at least for a while, is higher than interest.

If you have money in term deposits, the value of your money – expressed as how much you can buy with it – is falling.

That’s not good!

How laddering works

If you don’t want to move your money into other investments, I’d recommend laddering – setting up your deposits so they mature at different times.

Here’s how it works, step by step:

Let’s say you have $200,000 of retirement savings.

Step One: Divide the money into, say, four lots of $50,000.

Step Two: Invest $50,000 in a 1-year deposit, another $50,000 in a 2-year deposit, another $50,000 in a 3-year deposit, and the last $50,000 in a 4-year deposit.

Step Three: In a year’s time, when the first $50,000 matures, reinvest it for four years. When the others mature, reinvest each lot for four years.

Or you might want to ladder over the shorter term.

You could put, say, a third of your money in a 3-month deposit, a third in a 6-month deposit and a third in a 9-month deposit. When the first one matures, reinvest it for nine months, and keep reinvesting the others for nine months.

Why is this a good idea?

There are three reasons why laddering is a good idea:

  • Longer-term investments usually pay higher returns. Occasionally – when the experts are expecting interest rates to fall considerably – this won’t be the case. But generally, banks prefer customers to commit their money for longer, so they reward you with higher interest if you do that.
  • But you probably don’t want to tie up all your money for, say, four years. You never know when you might need some. And if you withdraw it early, there can be severe penalties. Once you’ve set up laddering, you’ll get the usually higher longer-term rates on all your money, but much more frequent access to some of it.
  • If interest rates are rising, when a portion of your money matures, you can reinvest it at the new, higher rate.

What can go wrong

Of course, the opposite can happen. When interest rates are falling, you’ll have to accept lower rates on some of your money, as it matures. But at least some of it will still be at the old, higher rates!

Laddering lets you adjust to the lower rates gradually. You’re diversified.

Most people prefer to spread their risk in this way, rather than taking the chance that the whole lot will mature when interest rates are really low.

Things to think about

  • You usually need a minimum amount to set up a term deposit, $1,000 or more.
  • Make sure you won’t need the money before the term ends. If you want to break a term deposit, you’ll probably have to give up to a month’s notice and pay a penalty fee.
  • Keep an eye out for your terms’ expiry dates. When some term deposits end, they automatically roll over to the interest rate that applies that day.
  • You can also ladder bonds in the same way.
  • I’m writing here about term deposits issued by banks. Other financial institutions offer term deposits too, sometimes with considerably higher interest rates. Some of them are probably safe investments, but I suggest you do lots of research before investing. Personally, if I want a higher return than on bank term deposits, I invest in managed funds at various risk levels.
  • It might be possible, if your mortgage lender is willing, to ladder your mortgage. You would fix, say, a quarter of the loan for six months, a quarter for one year, a quarter for 18 months and the last quarter for two years. Then renew each loan for two years. This spreads the risk of an interest rate rise, making it easier to adjust to it. Also, you’ll have the opportunity every six months to pay off a lump sum without penalty.

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