Certificate of Deposit

A certificate of deposit is a term deposit, which can be defined as financial product widely accessible to consumers in the United States offered by banks, thrift institutions and credit unions.

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 Generally, banks expect that the CD be held until the date of maturity, a time when the money can be withdrawn together with the accrued interest.

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duration, institutions typically offer higher interest rates as opposed to those accounts from which money may be withdrawn on demand, though this may not be the case in an inverted yield curve situation.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:

• A larger principal amount should receive a higher interest rate, but may not.
• A longer term will typically offered a higher interest rate, except for  an inverted yield curve (i.e. preceding a recession)
• Smaller institutions are likely to offer higher interest rates than larger ones.
• Personal CD accounts usually receive higher interest rates than business CD accounts.
• Banks and credit unions that are not insured by the FDIC or NCUA usually give higher interest rates.

How CDs work

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.

Closing a CD

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 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.

CD refinance

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.

Ladders

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).

Deposit insurance

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 rates offered se not the highest ones.

Terms and conditions

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.

• The terms and conditions can be changed. They may include language such as “We can add to, delete or make any other changes (“Changes”) we want to these Terms at any time.
• The CD may be callable. The terms might have a precondition that the bank or credit union can close the CD before the term matures..
• Payment of interest. Interest may be paid out as it accrues or it may added in the CD.
• Interest calculation. The CD may start receiving interest from the date of deposit or from the start of the next month or quarter.
• Right to delay withdrawals. Institutions normally have the right to holdup withdrawals for a specified period to stop a bank run.
• Withdrawal of principal. It might depend upon discretion of the financial institution. Withdrawal of principal below a certain minimum—or any withdrawal of principal whatsoever—may necessitate closure of the entire CD. A US Individual Retirement Account CD may let withdrawal of IRA Required Minimum Distributions without a withdrawal penalty.
• Withdrawal of interest. May be restricted to the most recent interest payment or allow for withdrawal of accrued 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. It can be measured in months of interest, may be calculated to be equal to the institution’s existing cost of replacing the money, or may make use of another formula. May or may not decrease the principal—for instance, if principal amount is withdrawn three months after opening a CD with a six-month penalty.
• Fees. A fee might be charged for withdrawal or closure or for providing a certified check.
• Automatic renewal. The institution may or may not be obliged in sending a notice before automatic rollover at CD maturity. The institution may spell out a grace period before automatically rolling over the CD to a new CD at maturity.

Limitations of CDs

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.