Information about 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.

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 It is intended that the CD be held until maturity, at which time the money may be withdrawn together with the accrued interest.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the agreed-on term, institutions usually grant higher interest rates than they do on accounts from which money may be withdrawn on demand, although this may not be the case in an inverted yield curve situation.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 which are indexed to the stock market, the bond market, or other indices are introduced.

A few general rules of thumb for interest rates are:

• The larger the principal, the higher the interest rate.
• The longer the term, the higher the interest rate. (Unless the yield curve is inverted.)
• The smaller the bank, the higher the interest rate.
• Personal CD accounts receive higher interest rates than business CD accounts.

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 to not "roll over" the CD).

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 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.

Other products

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.

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.

See also

• Time deposit

External links

• for a CD? Ask the right questions" North American Securities Administrators Association
• The US SEC on buying CDs
• FDIC on fraudulent CDs
• US Department of Justice case alleging sale of fraudulent CDs