Business, Legal & Accounting Glossary
A CD, or Certificate of Deposit, is a savings instrument issued by a bank or thrift. The CD pays interest on deposits held for the term of the CD. The interest rate on a CD is usually quoted as an annual percentage yield, or APY and is determined by competitive market forces. CD yields tend to vary across institutions. Early withdrawal of funds deposited to a CD generally incurs a penalty. Typical periods for a CD are 1 to 6, 9, 12, 18, 24, 30, 36, 48, or 60 months. A CD is sometimes called a time deposit. A jumbo CD is a CD having a minimum denomination of $100,000. Individuals and institutions alike can use the CD as a low-risk way to earn interest income.
A certificate of deposit (CD) is a money market instrument issued by a depository institution as evidence of a time deposit. Small-denomination certificates of deposit are issued to retail investors. In the United States, these usually are covered by deposit insurance. This article focuses on large-denomination certificates of deposit, which are issued to institutional investors for denominations generally exceeding USD 1.0MM.
A certificate of deposit has a fixed term. At the end of the term, the deposit is returned with interest. The vast majority of certificates of deposit have terms of under a year, with three months being typical. Certificates of deposit with terms of a year or more are called term CDs. Terms of five years are not unheard of.
Most certificates of deposit credit a fixed rate of interest, but there are also floating-rate certificates of deposit. A fee must be paid to withdraw funds early. Because most certificates of deposit are negotiable, investors usually sell an unwanted certificate of deposit rather than pay a fee and withdraw the funds. To facilitate transferability, most certificates of deposit are issued in bearer form, but some are registered.
Just like savings accounts, CDs are also insured and hence considered as almost risk-free investments. They only difference between savings accounts and certificates of deposits is that in latter case, there is a specific, fixed term (in most cases monthly, three months, six months, or one to five years), and, usually carry a fixed interest rate. Generally, banks expect that the CD be held until the date of maturity, a time when the money can be withdrawn together with the accrued interest.
Certificates of deposit fall into three general categories:
Domestic and foreign CDs are subject to the regulations of the country in which they are issued. Euro CDs are not. For this reason, Euro CDs have historically offered slightly higher yields.
Yields for terms less than a year are quoted as simple interest rates. An actual/360 basis is used almost everywhere, but certificates of deposit denominated in British pounds are usually quoted on an actual/365 basis. Yields depend primarily on a certificate of deposit’s term, the level of interest rates for the currency it is denominated in, and the credit quality of the issuer.
Depository institutions try to sell their certificates of deposit directly to investors. If their funding needs exceed their ability to directly market the certificates of deposit, they may also sell them to dealers, who then resell them. Dealers provide a secondary market in certificates of deposit. Brokers also arrange transactions. To preserve anonymity, inter-dealer transactions are often brokered.
CDs are insured by the Federal Deposit Insurance Corporation (FDIC) for banks and by the National Credit Union Administration (NCUA) for credit unions. In exchange for depositing the money for the agreed duration, institutions typically offer higher interest rates as opposed to those accounts from which money may be withdrawn on demand, though this may not be the case in an inverted yield curve situation.
Even though fixed rates are common, some institutions offer CDs with a range of variable rates. For instance, in mid-2004, when interest rates were likely to rise, many banks and credit unions started 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, CDs are also introduced that are benchmarked to the stock market, the bond market, or other indices.
A few common guiding principles for interest rates are:
CDs usually involve a minimum deposit and might offer higher rates for bigger deposits. In the US, the best rates are by and large offered on “Jumbo CDs” with minimum deposits of $100,000.
The consumer who maintains a CD account may receive a paper certificate, but it is now normal for a CD to consist simply of a book entry and an item shown in the consumer’s periodic bank statements; that is to say, there is often no “certificate” as such.
Withdrawals before the maturity are generally subject to a considerable penalty. For instance, in case of a five-year CD, a depositor can have to bear a loss of six months’ interest. Such hefty penalties ensure that it is normally not in a holder’s best interest to withdraw the money before the due date —except the holder has another investment with much higher return or is in a grave need for the money. Banks will always charge a penalty fee should the money is withdrawn from the CD before it matures.
Whenever the date of maturity nears, institutions mail a notice to the CD holder, requesting further directions. The notice generally offers the option of withdrawing the principal and accumulated interest or “rolling it over” (which is re-depositing and start a new CD). In general, a “window” is allowed after the maturity period where the CD holder can cash in the CD without paying the penalty.
Should the CD holder fails in providing directions at the time of maturity, the institution is likely to roll over the CD automatically, once more tying up the money for a fixed period of time.
In the U.S. insured CDs are expected by the “Truth in Savings Regulation DD” to reveal at the time of account opening the penalty for early withdrawal. It has been widely accepted that these penalties cannot be adjusted by the depository prior to maturity. However, there have been cases in the past where a credit union readjusted its early withdrawal penalty and made it retroactive on existing accounts.
This happened when Main Street Bank of Texas closed a group of CDs prematurely without full payment of interest. The bank maintained the disclosures allowed them to do so.
The penalty for premature withdrawal is the deterrent to allowing depositors to take benefit of subsequent enhanced investment opportunities throughout the term of the CD. During the period of rising interest rate environments, the penalty may be inadequate to prevent depositors from redeeming their deposit and reinvesting the proceeds after paying the appropriate premature withdrawal penalty. The extra interest from the new higher-yielding CD may more than compensate the cost of the early withdrawal penalty.
Even though longer investment terms yield higher interest rates, it has some limitations. There is an opportunity cost involved here. This is because; longer terms also may result in a loss of an opportunity for investors who fail to take advantage of higher interest rates in a rising-rate economy. A common approach for mitigating this opportunity cost is the “CD ladder” strategy. In the ladder strategies, the investor will open multiple CDs, each having different maturity period, stretching for several years with the objective of having all one’s money deposited at the longest term (and thus receiving a higher rate), but in a manner that part of it matures every twelve months. In this method, the depositor reaps the benefits of the longest-term rates at the same time as having the option to re-invest or withdraw the money in shorter-term intervals.
For instance, consider this: an investor using a three-year ladder strategy would start by depositing equal amounts of money each into a 3-year CD, 2-year CD, and 1-year CD. From this moment onwards, a CD will reach maturity every year, at which time the investor would re-invest at a 3-year term. As two years of this cycle ends, the investor will have all money deposited at a three-year rate, even as one-third of the deposits mature every year. This matured amount can then be reinvested, augmented, or withdrawn).
In the US, the amount of insurance coverage differs depending on how accounts for an individual or family are structured at the institution. The level of insurance is administered by complex FDIC and NCUA rules, accessible through FDIC and NCUA booklets or online. The standard insurance coverage is at present $250,000 per owner or depositor for single accounts or $250,000 per co-owner for joint accounts.
Some institutions employ a private insurance company as an alternative, in addition to, the federally backed FDIC or NCUA deposit insurance. Institutions often discontinue with private supplemental insurance when they realize that few customers have a high enough balance level to validate the additional cost.
The Certificate of Deposit Account Registry Service program makes possible for investors to maintain up to $50 million in CDs managed through one bank with full FDIC insurance. However, the rates offered are not the highest ones.
There is some dissimilarity in the terms and conditions for CDs.
In the US, the federally required ”Truth in Savings” booklet, or other disclosure document that offers the terms of the CD, have got to be made available before the purchase. Employees of the institution are normally not familiar with this information; merely the written document has a legal weight. In case of the original issuing institution merging with another institution, or if the CD is closed prematurely by the purchaser, or there is some other matter, the purchaser is required to refer to the terms and conditions document to make sure that the withdrawal is processed following the original terms of the contract.
CD interest rates moves in tandem with inflation. For instance, consider a situation where interest rates may be 15% and inflation may be 15%, or interest rates may be 2% and inflation may be 2%. In both of these cases, the real interest rate is zero. In addition, when taxes are included, the real rate of return will offer lower returns or negative rate of return, specifically when rates are high.
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This glossary post was last updated: 16th April, 2020 | 19 Views.