Certificate of Deposit Definition
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 The amount deposited for cannot be withdrawn till the maturity period, if it is withdrawn during the tenure of deposit then early withdrawal penalty needs to be paid. On maturity, principal amount and the interest on the same will be available for withdrawal, the depositor needs to decide the action on the matured amount.
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 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. 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 accounts. 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 institutions can issue a certificate of deposit. CD is issued by the bank to the individuals, mutual funds, 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 which 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 certificate of deposit before maturity. Banks have to consider the statutory liquid ratio (SLR) and cash reserve ratio (CRR) on the CD issue price.
Certificate of Deposit Examples
Below are the examples of the certificate of deposit (CD):
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:
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.
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 instruments like stocks, bonds, etc as the money deposited is safe with the banker.
- CD offer 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 asset 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.
- 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 investment. If the depositor has good money, and the same is not required for any use in 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 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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