HOME

TheInfoList



OR:

A certificate of deposit (CD) is a time deposit, a financial product commonly sold by
bank A bank is a financial institution that accepts deposits from the public and creates a demand deposit while simultaneously making loans. Lending activities can be directly performed by the bank or indirectly through capital markets. Because ...
s,
thrift institutions A savings and loan association (S&L), or thrift institution, is a financial institution that specializes in accepting savings deposits and making mortgage and other loans. The terms "S&L" or "thrift" are mainly used in the United States; simi ...
, and
credit union A credit union, a type of financial institution similar to a commercial bank, is a member-owned nonprofit financial cooperative. Credit unions generally provide services to members similar to retail banks, including deposit accounts, provisi ...
s in the United States. CDs differ from savings accounts in that the CD has a specific, fixed term (often one, three, or six months, or one to five years) and usually, a fixed
interest rate An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited, or borrowed (called the principal sum). The total interest on an amount lent or borrowed depends on the principal sum, the interest rate, ...
. The bank expects the CD to be held until maturity, at which time they can be withdrawn and
interest In finance and economics, interest is payment from a borrower or deposit-taking financial institution to a lender or depositor of an amount above repayment of the principal sum (that is, the amount borrowed), at a particular rate. It is distin ...
paid. Like savings accounts, CDs are insured "money in the bank" (in the US up to $250,000) and thus, up to the local insured deposit limit, virtually risk free. In the US, CDs are insured by the
Federal Deposit Insurance Corporation The Federal Deposit Insurance Corporation (FDIC) is one of two agencies that supply deposit insurance to depositors in American depository institutions, the other being the National Credit Union Administration, which regulates and insures cr ...
(FDIC) for banks and by the
National Credit Union Administration The National Credit Union Administration (NCUA) is a government-backed insurer of credit unions in the United States, one of two agencies that provide deposit insurance to depositors in U.S. depository institutions, the other being the Federa ...
(NCUA) for credit unions. In exchange for the customer depositing the money for an agreed term, institutions usually offer higher interest rates than they do on accounts that customers can withdraw from on demand—though this may not be the case in an
inverted yield curve In finance, an inverted yield curve happens when a yield curve graph of typically government bonds inverts in the opposite direction and the shorter term US Treasury bonds are offering a higher yield than the long-term Treasury bonds. Long ...
situation. Fixed rates are common, but some institutions offer CDs with various forms of variable rates. For example, in mid-2004, interest rates were expected to rise—and many banks and credit unions began to offer CDs with a "bump-up" feature. These allow for a single readjustment of the interest rate, at a time of the consumer's choosing, during the term of the CD. Sometimes, financial institutions introduce CDs indexed to the stock market,
bond market The bond market (also debt market or credit market) is a financial market where participants can issue new debt, known as the primary market, or buy and sell debt securities, known as the secondary market. This is usually in the form of bonds, bu ...
, or other indices. Some features of CDs are: * A larger principal should/may receive a higher interest rate. * A longer term usually earns a higher interest rate, except in the case of an inverted yield curve (e.g., preceding a recession). * Smaller institutions tend to offer higher interest rates than larger ones. * Personal CD accounts generally receive higher interest rates than business CD accounts. * Banks and credit unions that are not insured by the FDIC or NCUA generally offer higher interest rates. CDs typically require a minimum deposit, and may offer higher rates for larger deposits. The best rates are generally offered on "Jumbo CDs" with minimum deposits of $100,000. Jumbo CDs are commonly bought by large institutional investors, such as banks and pension funds, that are interested in low-risk and stable investment options. Jumbo CDs are also known as negotiable certificates of deposits and come in bearer form. These work like conventional certificate of deposits that lock in the principal amount for a set timeframe and are payable upon maturity. The consumer who opens a CD may receive a paper certificate, but it is now common for a CD to consist simply of a book entry and an item shown in the consumer's periodic bank statements. That is, there is often no "certificate" as such. Consumers who want a hard copy that verifies their CD purchase may request a paper statement from the bank, or print out their own from the financial institution's
online banking Online banking, also known as internet banking, web banking or home banking, is an electronic payment system that enables customers of a bank or other financial institution to conduct a range of financial transactions through the financial ins ...
service.


Closure

Withdrawals before maturity are usually subject to a substantial penalty. For a five-year CD, this is often the loss of up to twelve months' interest. These penalties ensure that it is generally not in a holder's best interest to withdraw the money before maturity—unless the holder has another investment with significantly higher return or has a serious need for the money. Commonly, institutions mail a notice to the CD holder shortly before the CD matures requesting directions. The notice usually offers the choice of withdrawing the principal and accumulated interest or "rolling it over" (depositing it into a new CD). Generally, a "window" is allowed after maturity where the CD holder can cash in the CD without penalty. In the absence of such directions, it is common for the institution to roll over the CD automatically, once again tying up the money for a period of time (though the CD holder may be able to specify at the time the CD is opened not to roll over the CD).


Refinancing

The Truth in Savings Regulation DD requires that insured CDs state, at time of account opening, the penalty for early withdrawal. It is generally accepted that these penalties cannot be revised by the depository prior to maturity. However, there have been cases in which a credit union modified its early withdrawal penalty and made it retroactive on existing accounts. The second occurrence happened when Main Street Bank of Texas closed a group of CDs early without full payment of interest. The bank claimed the disclosures allowed them to do so. The penalty for early withdrawal deters depositors from taking advantage of subsequent better investment opportunities during the term of the CD. In rising interest rate environments, the penalty may be insufficient to discourage depositors from redeeming their deposit and reinvesting the proceeds after paying the applicable early withdrawal penalty. Added interest from the new higher yielding CD may more than offset the cost of the early withdrawal penalty.


Ladders

While longer investment terms yield higher interest rates, longer terms also may result in a loss of opportunity to lock in higher interest rates in a rising-rate economy. A common mitigation strategy for this opportunity cost is the "CD ladder" strategy. In the ladder strategies, the investor distributes the deposits over a period of several years with the goal of having all one's money deposited at the longest term (and therefore the higher rate) but in a way that part of it matures annually. In this way, the depositor reaps the benefits of the longest-term rates while retaining the option to re-invest or withdraw the money in shorter-term intervals. For example, an investor beginning a three-year ladder strategy starts by depositing equal amounts of money each into a 3-year CD, 2-year CD, and 1-year CD. From that point on, a CD reaches maturity every year, at which time the investor can re-invest at a 3-year term. After two years of this cycle, the investor has all money deposited at a three-year rate, yet have one-third of the deposits mature every year (which the investor can then reinvest, augment, or withdraw). The responsibility for maintaining the ladder falls on the depositor, not the financial institution. Because the ladder does not depend on the financial institution, depositors are free to distribute a ladder strategy across more than one bank. This can be advantageous, as smaller banks may not offer the longer terms of some larger banks. Although laddering is most common with CDs, investors may use this strategy on any time deposit account with similar terms.


Step-up callable CD

Step-Up Callable CDs are a form of CD where the interest rate increases multiple times prior to maturity of the CD. These CDs are often issued with maturities up to 15 years, with a step-up in interest happening at year 5 and year 10. Typically, the beginning interest rate is higher than what is available on shorter-maturity CDs, and the rate increases with each step-up period. These CDs have a “call” feature which allows the issuer to return the deposit to the investor after a specified period of time, which is usually at least a year. When the CD is called, the investor is given back their deposit and they will no longer receive any future interest payments. Because of the call feature, interest rate risk is borne by the investor, rather than the issuer. This transfer of risk allows Step-Up Callable CDs to offer a higher interest rate than currently available from non-callable CDs. If prevailing interest rates decline, the issuer will call the CD and re-issue debt at a lower interest rate. If the CD is called before maturity, the investor is faced with
reinvestment risk Reinvestment risk is a form of financial risk. It is primarily associated with fixed income securities (including bonds), in the form of early redemption risk and coupon reinvestment risk. Early redemption One form of reinvestment risk is the ...
. If prevailing interest rates increase, the issuer will allow the CD to go to maturity.


Deposit insurance

The amount of insurance coverage varies, depending on how accounts for an individual or family are structured at the institution. The level of insurance is governed by complex FDIC and NCUA rules, available in FDIC and NCUA booklets or online. The standard insurance coverage is currently $250,000 per owner or depositor for single accounts or $250,000 per co-owner for joint accounts. Some institutions use a private insurance company instead of, or in addition to, the federally backed FDIC or NCUA deposit insurance. Institutions often stop using private supplemental insurance when they find that few customers have a high enough balance level to justify the additional cost. The
Certificate of Deposit Account Registry Service The Certificate of Deposit Account Registry Service (CDARS), was a US for-profit service that broke up large deposits (from individuals, companies, nonprofits, public funds, etc.) and placed them across a network of more than 3000 banks and sav ...
program lets investors keep up to $50 million invested in CDs managed through one bank with full FDIC insurance. However rates will likely not be the highest available.


Terms and conditions

There are many variations in the terms and conditions for CDs The federally required "Truth in Savings" booklet, or other disclosure document that gives the terms of the CD, must be made available before the purchase. Employees of the institution are generally not familiar with this information; only the written document carries legal weight. If the original issuing institution has merged with another institution, or if the CD is closed early by the purchaser, or there is some other issue, the purchaser will need to refer to the terms and conditions document to ensure that the withdrawal is processed following the original terms of the contract. *The terms and conditions may be changeable. They may contain language such as "We can add to, delete or make any other changes ("Changes") we want to these Terms at any time." *The CD may be callable. The terms may state that the bank or credit union can close the CD before the term ends. *Payment of interest. Interest may be paid out as it is accrued or it may accumulate in the CD. *Interest calculation. The CD may start earning interest from the date of deposit or from the start of the next month or quarter. *Right to delay withdrawals. Institutions generally have the right to delay withdrawals for a specified period to stop a bank run. *Withdrawal of principal. May be at the discretion of the financial institution. Withdrawal of principal below a certain minimum—or any withdrawal of principal at all—may require closure of the entire CD. A US
Individual Retirement Account An individual retirement account (IRA) in the United States is a form of pension provided by many financial institutions that provides tax advantages for retirement savings. It is a trust that holds investment assets purchased with a taxpayer's e ...
CD may allow withdrawal of
IRA Required Minimum Distributions Required minimum distributions (RMDs) are amounts that U.S. tax law requires one to withdraw annually from traditional IRAs and employer-sponsored retirement plans. In the Internal Revenue Code itself, the precise term is "minimum required distrib ...
without a withdrawal penalty. *Withdrawal of interest. May be limited to the most recent interest payment or allow for withdrawal of accumulated total interest since the CD was opened. Interest may be calculated to date of withdrawal or through the end of the last month or last quarter. *Penalty for early withdrawal. May be measured in months of interest, may be calculated to be equal to the institution's current cost of replacing the money, or may use another formula. May or may not reduce the principal—for example, if principal is withdrawn three months after opening a CD with a six-month penalty. *Fees. A fee may be specified for withdrawal or closure or for providing a
certified check A certified check (or certified cheque) is a form of check for which the bank verifies that sufficient funds exist in the account to cover the check, and so certifies, at the time the check is written. Those funds are then set aside in the bank's ...
. *Automatic renewal. The institution may or may not commit to sending a notice before automatic rollover at CD maturity. The institution may specify a grace period before automatically rolling over the CD to a new CD at maturity. Some banks have been known to renew at rates lower than that of the original CD.


Criticism

There may be some correlation between CD interest rates and inflation. For example, in one situation interest rates might be 15% and inflation 15%, and in another situation interest rates might be 2% and inflation may be 2%. Of course, these factors cancel out, so the
real interest rate The real interest rate is the rate of interest an investor, saver or lender receives (or expects to receive) after allowing for inflation. It can be described more formally by the Fisher equation, which states that the real interest rate is approxi ...
, which indicates the maintenance or otherwise of value, is both zero in these two examples. However the real rates of return offered by CDs, as with other fixed interest instruments, can vary a lot. For example, during a
credit crunch A credit crunch (also known as a credit squeeze, credit tightening or credit crisis) is a sudden reduction in the general availability of loans (or credit) or a sudden tightening of the conditions required to obtain a loan from banks. A credit cr ...
banks are in dire need of funds, and CD interest rate increases may not track inflation. The above does not include
taxes A tax is a compulsory financial charge or some other type of levy imposed on a taxpayer (an individual or legal entity) by a governmental organization in order to fund government spending and various public expenditures (regional, local, o ...
. When taxes are considered, the higher-rate situation above is worse, with a lower (more negative) real return, although the before-tax real rates of return are identical. The after-inflation, after-tax return is what is important. Author Ric Edelman writes: "You don't make any money in bank accounts (in real economic terms), simply because you're not supposed to." On the other hand, he says, bank accounts and CDs are fine for holding cash for a short amount of time. Even to the extent that CD rates are correlated with inflation, this can only be the ''expected'' inflation at the time the CD is bought. The actual inflation will be lower or higher. Locking in the interest rate for a long term may be bad (if inflation goes up) or good (if inflation goes down). For example, in the 1970s, inflation increased higher than it had been, and this was not fully reflected in interest rates. This is particularly important for longer-term notes, where the interest rate is locked in for some time. This gave rise to amusing nicknames for CDs. A little later, the opposite happened, and inflation declined. In general, and in common with other fixed interest investments, the economic value of a CD rises when market interest rates fall, and vice versa. Some banks pay lower than average rates, while others pay higher rates. In the United States, depositors can take advantage of the best FDIC-insured rates without increasing their risk. As with other types of investment, investors should be suspicious of a CD offering an unusually high rate of return. For example
Allen Stanford Robert Allen Stanford (born March 24, 1950) is an American financial fraudster, former financier, and sponsor of professional sports. He is serving a 110-year federal prison sentence, having been convicted in 2012 of fraud, on charges that his i ...
used fraudulent CDs with high rates to lure people into his Ponzi scheme.


References


External links


The US SEC on buying CDsNorth American Securities Administrators Association on buying CDs.
"...a scheme to defraud investors, many of them elderly, of approximately $3,661,248 by selling the investors fraudulent certificates of deposit."
Liberty Bank for Savings on CD Laddering
{{DEFAULTSORT:Certificate Of Deposit Bank deposits Retail financial services Interest-bearing instruments Money market instruments Investment in the United States