Certificate of deposit

A certificate of deposit or CD is a time deposit, a financial product commonly offered to consumers by banks, thrift institutions, and credit unions.

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 It is intended that the CD be held until maturity, at which time the money may be withdrawn together with the accrued interest.

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the agreed-on term, institutions usually grant higher interest rates than they do on accounts from which money may be withdrawn on demand, although this may not be the case in an inverted yield curve situation.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 guidelines for interest rates are:

• A larger principal should receive a higher interest rate, but may not.
• A longer term will usually receive a higher interest rate, except in the case of an inverted yield curve (i.e. preceding a recession)
• 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.

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. However there are also institutions that do the opposite and offer lower rates for their "Jumbo CDs". The consumer who opens a CD may receive a passbook or paper certificate, 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.

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 the holder has another investment with significantly higher return or has a serious need for the money.

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 not to roll over the CD).

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.

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.

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. The standard insurance coverage is currently $250,000 per owner or depositor for single accounts or $250,000 per co-owner for joint accounts until December 31, 2013. On January 1, 2014, the standard coverage limit will return to $100,000 per depositor for all accounts except for certain retirement accounts, which will remain at $250,000 per depositor.^[1]

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.

The Certificate of Deposit Account Registry Service program allows investors to keep up to $50 million invested in CDs managed through one bank with full FDIC insurance ^[2]. However rates will likely not be the highest available.

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.

• 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. Be careful as some otherwise respectable banks have been known to renew at scandalously low rates. ^[3].

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This 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.

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.

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 number 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 (e.g., "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, he/she 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 he/she 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.

In the event of bank failure, FDIC insurance applies but may be more difficult to realize. Direct deposit CDs are often allowed to mature at the original rate by the acquiring bank, but brokered accounts usually stop paying interest immediately. Brokered depositors may not be timely notified. Further, the FDIC will pay claims on direct deposits within 7-10 days, brokered CD claims may take 30-60 days. Additionally, the FDIC may require that brokered depositors prove they do not hold simultaneous direct and brokered deposits which exceed FDIC limits.

A Bump Up CD allows the account holder the option to increase the interest rate once during the term of the CD. Upon request, the bank will “bump up” the interest rate on the certificate of deposit to a higher rate being offered by the issuing bank on that CD (or a comparable term CD). The rate change does not change the original maturity date of the CD.

This type of CD is generally a fixed rate certificate of deposit, which allows you to withdraw a portion of the original deposit during the term without paying a penalty. There will be some limits on when you can take the money out, the amount that can be withdrawn and how many separate withdrawals you can make from the CD.

These can also be called a flex CD and can be confused with a Bump Up CD. Certificates of deposit with a step up or down feature have a fixed interest rate for a period of time, usually one year and then the interest rate automatically rises up to a predetermined rate or is lowered to a predetermined rate.

Unlike traditional CD's that pay a fixed rate of interest, a variable rate CD or index based CD is tied to the outcome of a market index. The interest you earn at maturity is based on the percentage gain (or loss) from the Initial Index to the final Index value.

These certificates of deposit can be tied to a bond or stock index or a reference rate like the Treasury bills, Prime Rate or the Consumer Price Index.

These are fixed or variable rate CDs to which you can make additional deposits. There can be restrictions, such as a minimum deposit that can be made to the account.

These certificates of deposit are issued at a substantial discount from the face amount of the CD. Typically the maturity terms are much longer, 15 to 20 years, which results in the discounted price. Zero coupon CDs do not pay interest until the maturity date.

CD interest rates closely track inflation.^[4] For example, in one situation interest rates may be 15% and inflation may be 15%, and in another situation interest rates may be 2% and inflation may be 2%. Of course, these factors cancel out, so the real interest rate is the same in both cases.

In this situation, it is a misinterpretation that the interest is an increase in value. However, to keep the same value the rate of withdrawal must be the same as the real rate of return, in this case, zero. People may also think that the higher-rate situation is "better," when the real rate of return is actually the same.

Also, the above does not include taxes.^[5] When taxes are considered, the higher-rate situation above is worse, with a lower (more negative) real return, although the before-tax real rates of return are identical. The after-inflation, after-tax return is what's important.

Ric Edelman writes, "You don't make any money in bank accounts (in real economic terms), simply because you're not supposed to."^[6]; on the other hand, bank accounts and CDs are fine for holding cash for a short amount of time.

However Mr. Edelman's opinions may apply only to "average" CD interest rates. In reality, some banks pay much lower than average rates while others pay much higher rates (differences of 100% are not unusual, eg, 2.50% vs 5.00%).^[7] In the United States, depositors can take advantage of the best FDIC-insured rates without increasing their risk.^[8] Furthermore, a long-term CD might have a high nominal interest rate with a relatively low real interest rate due to high inflation at the time of purchase (as indicated above); however inflation rates often change rapidly and the final real interest rate could be significantly higher than riskier investments.^[9]

Finally, Mr. Edelman's statement that "CD interest rates closely track inflation" is not necessarily true. For example, during a credit crunch banks are in dire need of funds and CD interest rate increases may not track inflation.^[10]

• The US SEC on buying CDs
• North American Securities Administrators Association on buying CDs.
• 2007 US Department of Justice filing "...a scheme to defraud investors, many of them elderly, of approximately $3,661,248 by selling the investors fraudulent certificates of deposit."