How to Maximize Your Passive Income From CDs

As of this writing, the highest-paying CDs on our radar have maturity terms of one year. If your goal is to simply maximize the amount of income you get today, the best course of action is to simply buy the CD with the highest rate.

The problem with that is that once the initial one-year term is up, there's no guarantee you'll be able to roll the money into a new CD that pays as much. In fact, if interest rates start to fall, it's entirely possible that 1-year CD yields could fall by 1%, 2%, or even more by the time your CD renews. And many people who want to use CDs to create a passive income stream (as opposed to compounding their money over the long run) need income for many years -- retirees, for example.

On the other hand, there are drawbacks to simply buying the highest-yielding long-term CDs you can find as well. Doing so sacrifices financial flexibility. And for the time being at least, 5-year CDs -- the longest standard term -- pay significantly less than short-term CDs.

With all of that in mind, a CD ladder could be the ideal way to blend maximum income with financial flexibility and income visibility.

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What is a CD ladder?

In simple terms, a CD ladder involves dividing your money into equal amounts and using it to buy a series of CDs with staggered maturities. While there's more than one way to create a CD ladder, if you had $10,000, here's what it might look like:

• $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

By setting it up like this, one of your CDs will mature every year. At that time, you'll roll it into a new 5-year CD. Eventually, you'll have a portfolio of nothing but 5-year CDs that pay long-term interest rates, but with some of your money maturing each year.

It's also worth noting that CDs generally renew automatically upon maturity unless you act. So you'll need to manually close your maturing CDs and use the money to open a new 5-year account. Otherwise, your 1-year CD will roll over into another 1-year CD.

A trifecta of passive income qualities

When you create a CD ladder, you might not get the absolute highest level of current income that is possible. But you get a great blend of three features that solid passive income sources should have:

• High income: By rolling all of your maturing balances into new, 5-year CDs (which historically pay higher rates), you'll be putting yourself in a good position to have a high income stream over time.
• Financial flexibility: With a CD ladder like the one described earlier, one-fifth of your money will mature every year, so you can assess whether you need to use some of it, or if it is best to reinvest it all.
• Income visibility: The biggest benefit to only one-fifth of your CD ladder reaching maturity each year is that it prevents sudden income shocks if rates rise or fall. Think of it like this: Even if interest rates collapse after you start a CD ladder, after one year, four-fifths of your CDs are still paying the same higher rates. By setting up a CD ladder, you'll be positioned to take advantage if rates rise, but can avoid massive income declines if they fall.

The bottom line is that if you rely on your CDs for income to cover your day-to-day expenses, a CD ladder can be a great way to get a high level of income with the predictability that is such a must-have.