Laddering Helps You Maximize Your Interest-based Income over Time

Retirees who have to live off their interest-based income investments are often a victim of interest rate swings that can lower their interest income significantly. Chasing after high interest rates without a strategy can often leave them with less income than they could get with a laddering strategy. Here's the situation...

*Interest-rate based investments and their behavior:

Interest-based investments come from certificates of deposit (CDs), bonds, and annuities. These types of investments tend to be more secure than stock-based investments. And that's what makes them attractive to those who depend on them for their living expenses.

But interest rates fluctuate over time; sometimes rising and then falling. This causes interest-based earnings - and the income they supply to people - also to vary. Everyone wants to lock in their interest-based investment when rates are high and not have to suffer through the low interest rate periods with a low income.

Additionally, at whatever the prevailing interests rates are¸ interest rate-based investments typically offer their higher rates for longer maturity investments. It's always nice to get the highest of the prevailing rates, but that means being locked into a longer maturity. That's a problem if prevailing rates are low - and especially if you think they may be going up soon.

*Chasing a higher interest rate can be a problem:

If you invest all you have when rates are historically high, that's great; you'll earn allot for your investment before they mature. However, when interest rates are low, you may have to invest because you need the income; but you don't want to be locked into low rates for a long term maturity in case interest rates go up. That presents a dilemma for you.

If you try to sell out of a long term maturity investment early to buy into rising rate investments, you'll generally pay a stiff penalty or suffer a loss of principal - as you would on a bond. You could buy shorter maturity units to preserve your ability to buy when rates go up, but that leaves you with even a lower rate than you could get at that time.

Without a strategy, you're forever chasing after a higher interest rate while getting less than the best rate at any one time. There is a better approach. And that's 'laddering your investment'.

*The Laddering Principle:

Laddering is based on dividing your investment money into equal parts - three, four, or even up to 10 parts. You need to work into the situation where each of these parts is invested at the longest maturity time to garner the highest prevailing rate when you bought that part; you'll hold each part to maturity with each maturing at successively later times. As each part reaches maturity, you reinvest it again at the highest prevailing rate.

Under this circumstance, you'll still be subject to changing interest rates, but your time-staggered investments will smooth out your income fluctuations and yet have them arise only from the highest rates that prevailed when bought.

*How do you begin to implement your laddering strategy?

For CDs and Bonds, you begin by dividing your full investment into perhaps 5 equal parts. The number of parts depends on the amount of money you have. Invest one part into the longest maturity investment to get the highest prevailing interest rate. Invest each remaining part with consecutively shorter time to maturity; you hold all them to that maturity, though. Obviously you'll get a lower interest on the shorter times; but that will change as time goes on.

Now as each investment comes to maturity, you'll reinvest it into the longest maturity possible. That'll get you the highest prevailing rate at that time. Keep this up, and you'll have all your parts invested at the longest maturities invested at the highest prevailing rates. Now you're properly laddered.

Annuities are handled somewhat analogously. But that's for another article.

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