A certificate of deposit (CD) is an investment instrument mostly issued by banks, requiring investors to lock in funds for a fixed term to earn high returns. CDs essentially require investors to set aside their savings and leave them untouched for a fixed period.
As a reward, the issuing financial entity offers premium interest rates. Coupled with the power of compoundingCompoundingCompounding is a method of investing in which the income generated by an investment is reinvested, and the new principal amount is increased by the amount of income reinvested. Depending on the time period of deposit, interest is added to the principal amount., investment earnings multiply with time, indicating higher the maturity tenure, the greater the returns.
- A certificate of deposit is defined as an investment vehicle that locks invested funds for a fixed tenure, and offers safer but lower rates of return as compared to stocks or bonds. They are mostly issued by banks and credit unions in exchange of an interest income.
- The tenure of CDs ranges from couple of days, a month, six months, a year five years to ten years.
- Interest rates offered could be fixed or floating and are usually paid monthly or semi-annually. Banks and credit unions adjust rates periodically as per changes in the Federal Reserve Rates.
- They come at a low risk with some being insured by government bodies. There is also a lack of liquidity as any withdrawal before maturity usually calls for a penalty.
- There are many types of CDs in the market with some being traditional type, liquid CD, jumbo type and broker CDs, etc.
Certificate of Deposit Explained
A certificate of deposit is a kind of fixed tenure investment instrument offered by banks, credit unions, and brokers working for a financial entity. Usually, a CD is understood as a kind of savings account that offers a higher interest rate than an ordinary savings account.
Although this edge over savings accounts comes at the cost of a lack of liquidityLiquidityLiquidity shows the ease of converting the assets or the securities of the company into the cash. Liquidity is the ability of the firm to pay off the current liabilities with the current assets it possesses.. While an ordinary bank account has no rules against using the deposit money as and when needed, CDs typically don’t allow withdrawals before the tenure ends. This hinders liquidity if an investor runs into a sudden cash requirement. The only way to withdraw the funds is by paying a penalty fee.
At the end of the term, investors receive the original investment value along with compounded interestCompounded InterestCompound Interest is the interest earned from the initial Principal & the previously accumulated Interest amount. This is also known as “Interest on Interest” & it is always higher than the Simple Interest. earnings. Add to that the safety and low risks they bring; CDs still remain a highly sought after investment. An investor can look through the web or visit a bank to learn about the various types of CDs offered. Maturity terms, interest rates, minimum balance requirement, penalty fees will all vary with the financial entity.
As such, one must jot down monthly financial requirements and a comfortable investment amount to set aside. Based on the above information, it will be easier to zero in on the product suited to one’s needs.
Certificate of Deposit Features
- Eligibility – A CD is usually issued by banks to individuals, mutual funds, trusts, companies, etc.
- Maturity Period – The investment is lock-in for a fixed tenure. Normally, tenures vary amongst different types of CDs with some having a maturity of a couple of days, a month, six months, a year, or five years. It could also be longer depending on the bank.
- Fixed Amount – The initial amount of investment which will be referred to as the principal here as well is fixed. Many banks often put forth a minimum investment requirement. The amount also varies as per financial institutionsFinancial InstitutionsFinancial 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. .
- Interest Rates – Investors earn interests in exchange of their investments. Rates could be fixed or floating. Interests are usually paid monthly or semi-annually. Banks and credit unions adjust rates periodically as per changes in the Federal Reserve Rates.
- Average Percentage Yield (APY) Usually, longer the fixed tenure, higher will be the rate. Moreover, due to compounding, and an absence of withdrawals, interests keep accumulating on the principal amount. With the interest charged on the accumulating principal each time, it reaps higher earnings. Some online banks offer high-yield certificates of deposit with annual percentage yield (APY) as high as 0.60%.
- Negotiable– Some CDs are negotiable, i.e. they can be sold in the secondary market.
- Low Risks – CDs come with very low risk and are highly safe investment since they are not that prone to fluctuations affecting stocks or bonds.
- Insured – Moreover, a federally insured bank offering CDs come with insurance up to $250,000.
Types of Certificates of Deposits (CDs)
- #1 – Traditional CD – It is an age-old type of CD that comes with a fixed rate of interest, strict penalty on early withdrawals and federal insurance. Think of it as a fixed deposit.
- #2 – Bump-Up CD – Under this type, if the CD interest rates increase after buying a CD, then Bump-up CD gives an option to raise the interest rate. 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. You’d have to wait for a rate hike by the bank to enjoy higher earnings. In case the rates aren’t increased, you’d be stuck with the initial rate.
- #3 – Step-Up CD – The step-up Certificate of Deposit works similar to the bump-up type. Although the incremental interest rate hikes happen on their own accord from the bank’s end. A depositor doesn’t need to personally ask the bank to raise the rates up. Hikes may be given effect with six months, nine months, or even one year in case of long term CD.
- #4 – Brokered CD – Brokered CDs is acquired through brokerage accounts. Brokers could represent a bank or financial entity. Sometimes multiple banks collaborate with a single agency. They offer ease in acquiring a CD since a broker takes care of the process. This CD offers better rates, but the risk is more as compared to a standard CD as they are negotiable and can be traded in the secondary market. Federal agencies often warn against illegitimate brokers disguised behind fake ids. As such, it is a must to confirm the validity of the agency they are representing before taking the plunge.
- #5 – 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 CDs pay less interest compared to the fixed period standard CD.
- #6 – Others – There are several other distinct types of CDs available in the market suited to inidividual needs such High-yield, Jumbo, IRA based, etc. Since terms of a CD varies vastly amongst banks, reading the fine print will help not missing out on any details that could bring down your earnings. Additionally, an investor can quickly compare possible earnings by using any relaible certificate of deposit calculator.
Certificate of Deposit Examples
A real-world example of a certificate of deposit could be those offered by commercial banks such as the Bank of America, Fidelity or Discover Bank, etc. For example, one of Bank of America’s products comes with a minimum balance of $10,000 with an option to choose terms between 7-35 months.
Let us look at some practical examples of the Certificate of Deposit to understand the concept better.
Joe invested $5,000 in CD with a bank at a fixed interest rate of 5%. The term of maturity was 5 years. The returns and maturity value of the CD are calculated as below:
Since the principal amount is $5,000, and the maturity proceeds are $6,382. The return on the CD for the period of 5 years is $1,382.
Tom invested $10,000 in a CD account with a bank. The interest rate was fixed at 5%, with the maturity being 5 years. Unfortunately, Tom had to withdraw the sum prematurely towards the end of 3rd year. As an early withdrawal penalty, Tom had to pay 6 months’ interest. Calculate Tom’s earnings and penalty charges.
|Year||Amount||Interest||Early Withdrawal Penalty|
In this case, the principal invested is $10,000 and the maturity proceeds at the end of the third year are $11,576.
The total returns for the period are $1,576. Since Tom withdrew money before the maturity, he had to pay a penalty of $276 (6 months interest = 551/2 = 276).
Avantages and Disadvantages
Let us have a look at the advantages and disadvantages of certificates of deposit.
- The risks are low with CDs as compared to other instruments such as stocks, bonds, etc. Being kept with banks, they are relatively safer from market fluctuations which stocks are prone to. Moreover, many have federal insurance coverage.
- CDs offer better returns for the amount deposited than the traditional savings account.
- Some online banks and institutions offer very high yielding products which an investor can explore to make better returns.
- Post maturity, a depositor has the option to reinvest their funds using rollover options into a new CD.
- It is not a liquid asset as the funds are blocked for a fixed duration. Any withdrawal of deposit before maturity in most cases will occur at the cost of a withdrawal penalty.
- With low risk, the returns are highly low as compared to stocks, or bonds.
- When the interest rates are fixed, it does not take into account changing inflation rates which offsets gains as compared to the cost.
A certificate of deposit (CD) is defined as an investment instrument mostly issued by banks, requiring investors to lock in funds for a fixed term to earn premium rates. It is like a savings account. For example, Joe invested $5,000 in CD with a bank at a fixed interest rate of 5% with 5 years maturity. Upon maturity, Joe’s initial investment of $5000 had reached $6,382. The return on CD for the period of 5 years was $1,382.
CDs are issued by banks, credit unions, and some financial entities.
A major difference between CDs and FDs is that CDs are more like savings account primarily offered by commercial banks. However, FDs are provided by many financial institutions, including NBFCs. Another difference is that FDs come with high rates of interest as compared to CDs. Lastly, CDs are negotiable and can be traded in the secondary market; most FDs don’t have this feature.
This has been a guide to What is the Certificate of Deposit (CD) and its Definition. Here we discuss the features of CDs, along with their types, examples, advantages, and disadvantages. You can learn more about accounting from the following articles –