What is a certificate of deposit? Definition and meaning
A certificate of deposit is an interest-bearing, short-term or medium-term debt instrument – a time deposit – commonly sold in the United States and many other countries by credit unions, banks and thrift institutions. It offers higher rates of return than the majority of comparable investments.
Owners of these low-risk time deposits have their money tied up for a specified length of time, from between three months to up to six years.
Certificates of deposit (CDs) are similar to savings accounts or deposit accounts – they are insured and virtually free of risk. In the United States, CDs are insured by the FDIC (Federal Deposit Insurance Corporation) for banks, and by the NCUA (National Credit Union Administration (NCUA) for credit unions.
A US $10,000-Certificate of Deposit, 1875. A certificate of deposit is a certificate issued by a financial institution to an individual depositing money for a specified length of time at a specified rate of interest. (Image: Wikimedia)
According to the Wall Street Journal, if the bank that issued your CD goes belly up, your deposit is insured by the FDIC for up to $250,000.
CDs have specific terms – typically 1, 3, 6 months, or 1-5 years, and usually at a fixed interest rate. The CD holder is expected to hold onto it until maturity.
CD’s are savings certificates which entitle the bearer to receive interest. They bear a maturity date, a specified fixed interest rate, and may be issued in a number of different denominations.
A certificate of deposit is an example of a promissory note, issued by a bank. This time-deposit restricts holders from cashing in on demand. However, it is still possible to withdraw the funds, although this action will generally incur a penalty.
When considering whether to purchase a CD, factor in tax and inflation when calculating how much money you will get.
Withdrawing funds before maturity typically means the loss of up to 12 months’ interest. These penalties discourage holders from withdrawing their money before maturity.
Certificates of deposit in the USA of less than $100,000 are known as small CDs, while those greater than $100,000 are called large CDs or Jumbo CDs. Virtually all CDs are negotiable.
Not all CDs offer fixed interest rates. In mid-2004, when interest rates were forecast to rise, several banks and credit unions started to offer CDs with a ‘bump up’ feature, which allowed for a single readjustment of the interest, at a time of the bearer’s choosing, during the CD’s term. Financial institutions sometimes introduce CDs indexed to the bond market, stock market, or other indices.
Types of Certificate of Deposit
Traditional CD: bearers receive a fixed rate of interest over a specified period. At maturity they can withdraw their money or roll it into another. Holders face a hefty penalty if they withdraw before maturity.
Zero-Coupon CD: rather than pay out annual interest, this type of CD re-invests the payments so that the holder ends up with more money at maturity. This type has slightly higher interest rates compared to other CDs.
Bump-Up CD: holders can alter the interest rate by swapping their CD for one with a similar maturity date – but provides a better return. Most financial institutions that offer Bump-up CDs allow the holder to raise the interest rate, and keep that higher rate for the remainder of the original CD’s duration.
Liquid CD: holders can withdraw part of their deposit penalty-free. Interest rates are usually slightly lower than other CDs, but still higher than in a bank savings account.
Brokered CD: any certificate of deposit offered by brokerages, which have access to thousands of banks’ CD offerings, including online ones. CDs from online and smaller institutions generally have higher interest rates.
Callable CD: the bank can recall this kind of CD after a set period, returning the deposit plus interest accrued to the holder. Financial institutions might do this if interest rates fall significantly below the initial rate. In order to attract investors, banks usually offer a higher interest rate. Callable CDs are usually offered through brokerages.
The US Securities and Exchange Commission says the following regarding certificates of deposit:
“A CD is a special type of deposit account with a bank or thrift institution that typically offers a higher rate of interest than a regular savings account. Unlike other investments, most CDs feature federal deposit insurance up to $250,000.”
“When you purchase a CD, you invest a fixed sum of money for a fixed period of time – six months, one year, five years, or more – and, in exchange, the issuing bank pays you interest, typically at regular intervals.”
“When you cash in or redeem your CD, you receive the money you originally invested plus any accrued interest. If you redeem your CD before it matures, you may have to pay an “early withdrawal” penalty or forfeit a portion of the interest you earned.”
The US Securities and Exchange Commission (SEC) advises consumers not to be dazzled by high yields. For some people, the right CD might have a lower yield and less risk than other CD’s they are considering.
Before buying a CD, consumers need to make sure they fully understand all of its terms, and read its disclosure statement carefully.
“Remember to ask questions and check out the answers with an unbiased source. These basic tips can help you decide if you’re picking a CD that’s appropriate for you,” the SEC adds.
Before you buy a certificate of deposit:
– Check the terms carefully
– Read its disclosure statement thoroughly
– Get expert advice from an unbiased source
– Think about your financial goals and risk tolerance
– Make sure you know when the CD matures – your money could be tied up for a long time
– Investigate any call features
– Make sure you understand the difference between a CD’s maturity date and call period. Do not assume that a ‘federally insured 1-year non-callable’ CD matures in one year, because it doesn’t. It means the financial institution cannot redeem the CD during the first year – it has nothing to do with its maturity date.
Video – Certificate of Deposit: Two Warnings
This ProfessorSavings video warns people considering purchasing CDs to bear in mind that both tax and inflation will reduce their expected return considerably.