Certificate of Deposit
Certificate of Deposit
What It Means
A certificate of deposit (CD) is a short-to-medium-term investment offered by banks, savings and loan associations, and credit unions. As with savings accounts, the customer deposits money with the institution and in exchange receives a fee called interest, which is calculated as a percentage of the amount deposited (for instance, 3 percent interest on a $100 deposit is $3). Also known as a time deposit, a CD earns a higher interest rate than a regular savings account, because the investor agrees not to make any withdrawals on the money for a fixed amount of time, called the maturity period. In effect, purchasing a CD is like lending money to the bank in exchange for a favorable interest rate. When the CD matures (has been held for the agreed-upon length of time), the investor may redeem it for the original amount of the investment plus any interest that has accrued (accumulated).
While it is possible for the investor to withdraw money from the CD before the maturity date is reached, there is a significant penalty for doing so; this is usually calculated by subtracting from the amount of interest earned. In the past the investor received a paper certificate as receipt for his or her investment (hence the term certificate of deposit), but this practice has become less common; it is now more likely that the CD will simply be represented as an item in the investor’s monthly bank statement.
A certificate of deposit is generally considered to be one of the safest investments a person can make, because the deposit is backed by the FDIC (Federal Deposit Insurance Corporation) or the NCUA (National Credit Union Administration). Both the FDIC and the NCUA guarantee the stability of the U.S. financial system by insuring the deposits of their member institutions for up to $100,000 per depositor.
When Did It Begin
Certificates of deposit were introduced in the nineteenth century as a way for way for banks to borrow money from investors in order to fund their own investments and operations. Certificates of deposit increasingly enabled banks to compete with other institutions (such as the U.S. Treasury, which offers savings bonds; and finance companies, which offer a variety of investments) for the uninvested dollars of individuals and corporations.
Particularly useful because of its large denomination was the “negotiable certificate of deposit” (or NCD), a CD with a face value of at least $100,000. NCDs were introduced in 1961. Usually purchased by insurance companies, corporations, or other institutional investors, NCDs may be sold in secondary markets (from one investor to another) at a substantial profit, although they cannot be drawn upon before the maturity date.
More Detailed Information
Before purchasing a CD from one financial intuition or another, it is essential to understand the specific terms of the investment.
The Minimum Deposit
Financial institutions typically require a minimum deposit of $500 to purchase a CD. Some institutions may stipulate higher minimums of $1,000, $2,500, $10,000, or more. CDs of less than $100,000 are considered “small CDs,” while those over $100,000 are called “large CDs,” “jumbo CDs,” or “negotiable CDs” (often referred to as NCDs).
The Maturity Period
CDs are sold with maturity periods in increments of 31 days and 3, 6, 12, 18, 24, 36, 48, and 60 months. In many cases, investors time their CDs to reach maturity in advance of some anticipated expense, such as a tax payment, a child’s college tuition, or a luxury vacation. At the time of maturity, the investor may cash out the CD, receiving back the amount of the principal along with the accrued interest. He or she may also elect to “roll it over,” depositing the money into a new CD.
The Annual Percentage Rate of Interest (APR)
CDs usually carry a fixed annual percentage rate (APR) by which interest is calculated. In most cases, the larger the deposit and the longer the maturity period, the higher the interest rate will be. In 2005 average APRs for CDs ranged from 2.29 percent (for a 3-month maturity) to 4.09 percent (for a 60-month maturity).
How Interest Accrues
The interest on certificates of deposit is referred to as compounding interest. This means that the interest builds upon itself. For example, if Darrin buys a $500 CD with a three-year maturity at a 4 percent APR, then at the end the first year he will have earned $20 in interest; his investment will then be worth $520. If the interest compounds annually, then over the course of the second year he will earn $20.80 in interest, because the interest is calculated based on the $520 that is now in the account. Although the extra 80 cents may seem insignificant, continually increasing interest can add up. Interest may be set to compound daily, monthly, quarterly (every three months), or annually. The shorter the compounding period, the more quickly interest will accrue.
Most institutions allow the investor to choose how she wishes to receive interest. For example, she may elect to leave the interest in the CD (in which case it continues to compound), to receive a monthly or quarterly check for the interest accrued, or to have the interest credited to another checking or savings account in monthly or quarterly installments (the two latter choices would mean that interest would not compound).
Penalties for Early Withdrawal
If the investor decides to draw on the funds in a CD before the maturity date is reached, he will incur a significant penalty. For example, the terms of a one-year CD may state that “the penalty is equal to 180 days’ interest on the amount of principal withdrawn” and that “if the early-withdrawal penalty is greater than the interest earned, the difference will be deducted from principal.” To apply those terms to a specific example, suppose that Gwen purchases a $1,000, one-year CD with a 3.6 percent APR. One month into the maturity period, however, she needs to cash out the CD because of a family emergency. At the end of one month, the CD has earned $3 in interest; but the penalty for early withdrawal is the interest that she would have earned in 180 days (six months), or $18; therefore, when Gwen cashes out the CD, the total money she receives is $985 ($1,003 minus $18). Penalties provide a strong incentive for investors to leave their money in the bank until the maturity date. Still, however, an investor might be willing to accept the penalty if he or she has the opportunity to reallocate the money toward an investment that yields a greater return (such as one with a higher interest rate) or if he or she simply has an urgent need to access the funds right away.
Introduced in 1994, the “callable CD” features an important variation on the traditional certificate of deposit. Like the traditional CD, the callable CD is issued by a bank, savings and loan, or credit union; is insured by the FDIC or NCUA up to $100,000; pays a specific interest rate; and carries a preset maturity period, at the end of which the investor is repaid the principal amount of the CD along with any interest earned.
Unlike the traditional CD (for which the maturity date does not exceed 5 years), however, the callable CD carries a typical maturity period of 10 to 15 years and contains a “call” feature. This entitles the bank to call (buy back) the CD at its discretion before the maturity date is reached, usually after 12, 18, or 24 months. In exchange for accepting a level of uncertainty about the CD, the investor benefits from a premium interest rate.
Usually a bank will exercise its option to call a CD if fluctuations in the economy lead to a drop in national interest rates, causing the interest rate on the CD to be higher than the going rate (meaning that the bank is paying the investor too much interest on the money it has borrowed). Conversely, a bank is likely to waive its call option and allow a CD to reach maturity if national interest rates rise above the fixed level on the CD (meaning that the bank is paying the investor less than the going rate on the money it has borrowed).
Because callable CDs are susceptible to fluctuations in market interest rates, they are not ideal for elderly investors and others who are looking for stable investments with predictable maturity periods.
certificate of deposit
cer·tif·i·cate of de·pos·it (abbr.: CD) • n. a certificate issued by a bank to a person depositing money for a specified length of time.
Certificate of Deposit
CERTIFICATE OF DEPOSIT
A written recognition by a bank of a deposit, coupled with a pledge to pay the deposited amount plus interest, if any, to the depositor or to his or her order, or to another individual or to his or her order.
A form ofcommercial paperthat serves as documentary evidence that a savings account exists.