“I want the best rates, but … how do I protect myself against interest rate fluctuations?”

Interest rates can never please everyone, borrowers want them low and investors want them high.

Since most of us are both, we are stuck somewhere in the middle. For loans, mortgage borrowers especially have the tendency to ride the low rates maximizing the interest savings by signing short-term loan agreements. Investors, on the other hand, hold out for the highest rate, which typically means locking all their investments in at the longest term. By following this method the investor has some protection if the interest rates drop, but cannot easily take advantage of interest rate increases. There is a strategy referred to as laddering which allows this type of protection. By investing in a number of terms with different maturities the interest rate risk is spread across the entire portfolio.

How a ladder term works

The first step is to decide how much of an investment you are making. For our example we will take $30,000. To protect the investment from interest rate decreases you want a portion in longer terms as these are the highest rates. But if rates go up you want part of your investment to be available, so you need shorter term investments. The initial $30,000 is divided into 5 equal amounts of $6,000. Then 5 different investments are opened; 1-year, 2-year, 3-year, 4-year and 5-year terms. As each one matures it is rolled into a 5-year term as this is typically the highest interest rate available.

How the investment is protected

By the end of the 5th year, all investments are earning the highest amount of interest and you have a portion maturing every year to take advantage of interest rate increases. If interest rates have dropped only 20% of your investment is affected. In this way you are protected against interest rate fluctuation.

How to keep it working

A laddering strategy works best if you are able to maintain your investments over the longer term. Since most of us are investing for a reason such as retirement, saving for a down payment on a house or some other goal you need to think about the timing of your laddering so you have funds available when needed. There are two different scenarios to think about.

If you need the entire investment amount at some date in the future work out the timing in advance so, as the terms start to come due in the five years before it is needed you can roll them into shorter time frames. In that way you will have the money maturing when you need it. In essence you will be ‘walking’ back down the ladder. So, four years before you take the maturing amount and invest it in a 4-year term, at three years invest in a 3-year term and so on. By the time you need the funds all of your terms will be maturing and you took advantage of the highest possible rates you could. If you only need some of the investment, you can consider taking a portion of each maturing investment and putting it into a shorter-term investment or high yield savings account each year so you maintain the ladder at the same time as you are saving for the purchase.

Some investors roll a maturing investment into the same term, so the 2-year matures into a 2-year and the 3-year matures into a 3-year. This is still laddering but interest income is decreased as investments are not in the longest terms.

The first step in deciding whether a laddering strategy is best for you is to speak with your financial advocate. We will look at your current financial situation and help you figure out how best to meet your financial goals today and into the future. Whether you are ready to set-up your first investment or your twenty-fifth, We C.U.™ so you can reduce your risk and maximize your return.