A certificate
of deposit or CD is a time deposit, a financial product
commonly offered to consumers by banks, thrift institutions, and
credit unions.
Such CDs are
similar to savings accounts in that they are insured and thus
virtually risk-free; they are "money in the bank" (CDs are insured
by the FDIC for banks or by the NCUA for credit unions). They
are different from savings accounts in that the CD has a specific,
fixed term (often three months, six months, or one to five years),
and, usually, a fixed interest rate. It is intended that the CD
be held until maturity, at which time the money may be withdrawn
together with the accrued interest.
Rates
In exchange
for keeping the money on deposit for the agreed-on term, institutions
usually grant higher interest rates than they do on accounts from
which money may be withdrawn on demand, although this may not
be the case in an inverted yield curve situation. Fixed rates
are common, but some institutions offer CDs with various forms
of variable rates. For example, in mid-2004, with interest rates
expected to rise, many banks and credit unions began 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 that are indexed to the stock
market, the bond market, or other indices are introduced.
A few general
rules of thumb for interest rates are:
- A larger
principal should receive a higher interest rate, but may not.
- A longer
term may or may not receive a higher interest rate, depending
on the current yield curve.
- Smaller
institutions tend to offer higher interest rates than larger
ones.
- Personal
CD accounts generally receive higher interest rates than business
CD accounts.
- Banks and
credit unions that are not insured by the FDIC or NCUA generally
offer higher interest rates.
How
CDs work
The consumer
who opens a CD may receive a passbook or paper certificate, but
it now is common for a CD to consist simply of a book entry and
an item shown in the consumer's periodic bank statements; that
is, there is usually no "certificate" as such.
At most institutions,
the CD purchaser can arrange to have the interest periodically
mailed as a check or transferred into a checking or savings account.
This reduces total yield because there is no compounding. Some
institutions allow the customer to select this option only at
the time the CD is opened.
Commonly,
institutions mail a notice to the CD holder shortly before the
CD matures requesting directions. The notice usually offers the
choice of withdrawing the principal and accumulated interest or
"rolling it over" (depositing it into a new CD). Generally, a
"window" is allowed after maturity where the CD holder can cash
in the CD without penalty. In the absence of such directions,
it is common for the institution to "roll over" the CD automatically,
once again tying up the money for a period of time (though the
CD holder may be able to specify at the time the CD is opened
that it is not to be automatically rolled over).
CDs typically
require a minimum deposit, and may offer higher rates for larger
deposits. In the US, the best rates are generally offered on "Jumbo
CDs" with minimum deposits of $100,000 (though some, recognizing
that some investors don't want more in the account than is covered
by FDIC insurance, have lowered the minimum deposit to $95,000).
However there are also institutions that do the opposite and offer
lower rates for their "Jumbo CDs".
Withdrawals
before maturity are usually subject to a substantial penalty.
For a five-year CD, this is often the loss of six months' interest.
These penalties ensure that it is generally not in a holder's
best interest to withdraw the money before maturity—unless they
have another investment with significantly higher return or have
a serious need for the money.
CD
refinance
In the U.S.
insured CDs are required by the Truth in Savings Regulation DD
to state at the time of account opening the penalty for early
withdrawal. These penalties cannot be revised by the depository
prior to maturity. The penalty for early withdrawal is the deterrent
to allowing depositors to take advantage of subsequent enhanced
investment opportunities during the term of the CD. In rising
interest rate environments the penalty may be insufficient to
discourage depositors from redeeming their deposit and reinvesting
the proceeds after paying the applicable early withdrawal penalty.
The added interest from the new higher yielding CD may more than
offset the cost of the early withdrawal penalty.
Ladders
While longer
investment terms yield higher interest rates, longer terms also
may result in a loss of opportunity to lock in higher interest
rates in a rising-rate economy. A common mitigation strategy for
this opportunity cost is the "CD ladder" strategy. In the ladder
strategies, the investor distributes the deposits over a period
of several years with the goal of having all one's money deposited
at the longest term (and therefore the higher rate), but in a
way that part of it matures annually. In this way, the depositor
reaps the benefits of the longest-term rates while retaining the
option to re-invest or withdraw the money in shorter-term intervals.
For example,
an investor beginning 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 point on, a CD will reach maturity
every year, at which time the investor would re-invest at a 3-year
term. After two years of this cycle, the investor would have all
money deposited at a three-year rate, yet have one-third of the
deposits mature every year (which can then be reinvested, augmented,
or withdrawn).
The responsibility
for maintaining the ladder falls on the depositor, not the financial
institution. Because the ladder does not depend on the financial
institution, depositors are free to distribute a ladder strategy
across more than one bank, which can be advantageous as smaller
banks may not offer the longer terms found at some larger banks.
Although laddering is most common with CDs, this strategy may
be employed on any time deposit account with similar terms.
Deposit
insurance
In the US,
the amount of insurance coverage varies depending on how accounts
for an individual or family are structured at the institution.
The level of insurance is governed by complex FDIC and NCUA rules,
available in FDIC and NCUA booklets or online. Basic Coverage
is $100,000 for a single account and $200,000 for a joint account.
As of April 1, 2006, Individual Retirement Accounts are insured
up to $250,000.
Some institutions
use a private insurance company instead of, or in addition to,
the Federally backed FDIC or NCUA deposit insurance. Institutions
often stop using private supplemental insurance when they find
that few customers have a high enough balance level to justify
the additional cost.
A program
called the "Certificate of Deposit Account Registry Service" allows
you to keep up to $25 million invested in CDs at one bank and
have it all covered by FDIC insurance. [1]
Terms
and conditions
There are
many variations in the terms and conditions for CDs.
In the US,
the Federally required "Truth in Savings" booklet, or other disclosure
document that gives the terms of the CD, must be made available
before the purchase. Employees of the institution are generally
not familiar with this information; only the written document
carries legal weight. If the original issuing institution has
merged with another institution, or if the CD is closed early
by the purchaser, or there is some other issue, the purchaser
will need to refer to the terms and conditions document to ensure
that the withdrawal is processed following the original terms
of the contract.
Key terms
and conditions of a certificate of deposit include:
- The
CD may be "callable." The terms may state that the bank
or credit union can close the CD before the term ends.
- Payment
of interest. Interest may be paid out as it is accrued or
it may accumulate in the CD.
- Interest
calculation. The CD may start earning interest from the
date of deposit or from the start of the next month or quarter.
- Right
to delay withdrawals. Institutions generally have the right
to delay withdrawals for a specified period to stop a bank run.
- Withdrawal
of principal. May be at the discretion of the financial
institution. Withdrawal of principal below a certain minimum
or any withdrawal of principal at all may require closure of
the entire CD. A US Individual Retirement Account CD may allow
withdrawal of IRA Required Minimum Distributions without a withdrawal
penalty.
- Withdrawal
of interest. May be limited to the most recent interest
payment or allow for withdrawal of accumulated total interest
since the CD was opened. Interest may be calculated to date
of withdrawal or through the end of the last month or last quarter.
- Penalty
for early withdrawal. May be measured in months of interest,
may be calculated to be equal to the institution's current cost
of replacing the money, or may use another formula. May or may
not reduce the principal—for example, if principal is withdrawn
three months after opening a CD with a six-month penalty.
- Fees.
A fee may be specified for withdrawal or closure or for providing
a certified check.
- Automatic
renewal. The institution may or may not commit to sending
a notice before automatic rollover at CD maturity. The institution
may specify a grace period before automatically rolling over
the CD to a new CD at maturity.
Other
similar products
productsThis
article has described the familiar FDIC-insured or NCUA-insured
CDs which are usually purchased by consumers directly from banks
or credit unions. There are also "certificates of deposit" issued
by various entities that do not carry insurance.
Callable
CDs
A callable
CD is similar to a traditional CD, except that the bank reserves
the right to "call" the investment. After the initial non-callable
period, the bank can buy (call) back the CD. Callable CDs pay
a premium interest rate. Banks manage their interest rate risk
by selling callable CDs. On the call date, the banks determine
if it is cheaper to replace the investment or leave it outstanding.
This is similar to refinancing a mortgage.
Brokered
CDs
Many brokerage
firms known as "deposit brokers" offer CDs. These brokerage firms
can sometimes negotiate a higher rate of interest for a CD by
promising to bring a certain amount of deposits to the institution.
Unlike traditional
bank CDs, brokered CDs are sometimes held by a group of unrelated
investors. Instead of owning the entire CD, each investor owns
a piece. If several investors own the CD, the deposit broker may
not list each person's name in the title but the account records
should reflect that the broker is merely acting as an agent (eg,
"XYZ Brokerage as Custodian for Customers"). This ensures that
each portion of the CD qualifies for up to $100,000 of FDIC coverage.
In some cases,
the deposit broker may advertise that the CD does not have a prepayment
penalty for early withdrawal. In those cases, the deposit broker
will instead try to resell the CD if the investor wants to redeem
it before maturity. If interest rates have fallen since the CD
was purchased, and demand is high, s/he may be able to sell the
CD for a profit. But if interest rates have risen, there may be
less demand for such lower-yielding CD, which means that s/he
may have to sell the CD at a discount and lose some of the investor’s
original deposit.
Deposit brokers
do not have to go through any licensing or certification procedures,
and no state or federal agency licenses, examines, or approves
them.
References
-
CDARS:
An easy way to beat the $100,000 FDIC limit. Retrieved on
2008-02-10.
External
links
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