Certificate of Deposit (Definition, Example)| CD Advantages/Disadvantages

Certificate of Deposit Definition

A certificate of deposit (CD) is a money market instrument issued by a bank to raise funds from the secondary money market. It is issued for a specific period for a fixed amount of money with a fixed rate of interest. It is an arrangement between the depositor of money and the bank.

CD is issued in dematerialized form. The amount deposited for cannot be withdrawn till the maturity period. If it is withdrawn during the tenure of deposit, then the early withdrawal penalty needs to be paid. On maturity, the principal amount and the interest on the same will be available for withdrawal, and the depositor needs to decide the action on the matured amount.

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Types of the Certificate of Deposit (CD)

#1 – Liquid or “No penalty” CD – The liquid CD allows the depositor to withdraw the money during the tenure without payment of any early withdrawal penalty. It is flexible enough to shift the funds from one CD to a higher paying CD. Liquid Certificate of Deposit pays less interest compared to the fixed period standard CD.
#2 – Bump-Up CD – Bump-Up CD gives the benefit like a liquid CD. If the CD interest rates increase after buying a CD, then Bump-up CD gives an option to switch over to high-interest CD. To exercise this option, the same needs to be informed by the depositor to the bank in advance. Bump up CD also pays lower interest compared to the Standard CD
#3 – Step-Up CD – The step-up CD works with a regularly planned interest rate increase, so the depositor doesn’t get paid with the lower interest rate, which is fixed at the time of opening the CD. An increase in interest rate may be given effect with six months, nine months, or even one year in case of long term CD.
#4 – Brokered CD – Brokered Certificate of Deposit is sold in brokerage accountsBrokerage Accounts A brokerage account is a taxable investment account in a brokerage company where a person deposits its assets and instructs the company to trade in shares or bonds on their behalf. In addition, the company deducts some brokerage or commission.read more. This CD can be bought from various banks and can be kept in one place instead of opening a bank account and buying the CD. This CD offers better rates, but the risk is more in this compared to a standard CD.
#5 – Jumbo CD – In Jumbo CD minimum balance is very high compared to the standard one. It is safe to park a large sum of money as the same is FDIC insured, and the interest rates are also high in this CD.

Features of the Certificate of Deposit (CD)

Eligibility – Scheduled Commercial banks/ financial institutionsFinancial Institutions Financial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. read more can issue a certificate of deposit. CD is issued by the bank to the individuals, mutual fundsMutual Funds A mutual fund is an investment fund that investors professionally manage by pooling money from multiple investors to initiate investment in securities individually held to provide greater diversification, long term gains and lower level of risks.read more, trusts, companies, etc.
Maturity Period – CDs are issued by scheduled commercial banks for a period ranging from 7 days to one year. For Financial institutions, the period ranges from one year to three years.
Transferability – CDs that are in physical form can be transferred to by endorsement and delivery. CDs, which are in dematerialized form, can be transferred like any other dematerialized securities.
Loan Against CD – CDs do not have any lock-in period, so banks do not grant loans against them. Banks cannot even buyback certificates of deposit before maturity. Banks have to consider the statutory liquid ratio (SLR) and cash reserve ratioCash Reserve Ratio Cash Reserve Ratio refers to the share of a Bank’s total deposits that need to be maintained with the respective Country’s Central Bank to control financial supply in the economy. read more (CRR) on the CD issue price.

Certificate of Deposit Examples

Below are the examples of the certificate of deposit (CD):

You can download this Certificate of Deposit Excel Template here – Certificate of Deposit Excel Template

Example #1

Joe invested $5,000 in CD with the bank at a fixed interest rate of 5% and maturity in 5 years. The Returns and maturity value of CD is calculated as below:

Certificate of Deposit

Year	Amount	Interest
0	5000	0
1	5250	250
2	5513	263
3	5788	276
4	6078	289
5	6381	304

So the principal amount is $5,000, and the maturity proceeds are $6,381. The return on CD for the period of 5 years is $1,381.

Example #2

Tom invested $10,000 in CD with the bank at a fixed interest rate of 5% and maturity in 5 years. He decides to withdraw the money before maturity at the end of year 3. The early withdrawal penalty is 6 months’ interest.

Certificate of Deposit

Year	Amount	Interest	Early Withdrawl Penalty
0	10000	0
1	10500	500
2	11025	525
3	11576	551	276

In this case, the principal invested is $10,000 and the maturity proceeds at the end of year 3 are $11,576. The total returns for the period are $1,576. Since Tom withdraws money before the maturity period, he needs to pay an early withdrawal penalty of $276 (6 months interest).

Advantages of Certificate of Deposit (CD)

Risk is less in CD compared to other money market instrumentsMoney Market Instruments The money market is a market where institutions and traders trade short-term and open-ended funds. It enables borrowers to readily meet finance requirements through any financial asset that can be readily converted into money, providing an organization with a high level of liquidity and transferability.read more like stocks, bonds, etc., as the money deposited is safe with the banker.
CD offers better returns for the amount deposited than the traditional deposit schemes.
Post maturity options are given to the depositor to use their funds like rollover of the CD into a new CD, transfer the funds to another account at that bank or withdraw the maturity money, and it can be transferred to another bank account, or cheque can be received for the money.

Disadvantages of Certificate of Deposit (CD)

It is not a liquid assetLiquid Asset Liquid Assets are the business assets that can be converted into cash within a short period, such as cash, marketable securities, and money market instruments. They are recorded on the asset side of the company's balance sheet.read more as the funds are blocked for a fixed duration and any withdrawal of deposit before the maturity period is possible only if the early withdrawal penalty is paid.
Its returns are less than stocks, bonds, etc. over a period of time.
The interest rate is fixed and does not vary according to inflation/ market scenario, and it does not give effect to changes in the interest rates during the tenure.

Conclusion

CD is one of the safe and high return investments. If the depositor has good money, and the same is not required for any use in the near future, then the same can be invested in CD as it yields higher interest than the traditional bank deposits, and it is safer compared to the other money market instruments. The blocked money can also be withdrawn on the payment of penalty.

Banks issue CD only when the incoming of deposits in the bank is getting reduced, whereas there is a high demand for loans and credits. CDs cost the bank more than the traditional deposits so, it is issued only when there are liquidity issues in the market.

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Certificate of Deposit (CD)