Certificate of deposit

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A certificate of deposit (CD) is a time deposit, a financial product commonly sold by banks, thrift institutions, and credit unions. CDs differ from savings accounts in that the CD has a specific, fixed term (often one, three, or six months, or one to five years) and usually, a fixed interest rate. The bank expects CD to be held until maturity, at which time they can be withdrawn and interest paid.

Contents

Like savings accounts, CDs are insured "money in the bank" (in the US up to $250,000) and thus, up to the local insured deposit limit, virtually risk free. In the US, 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 the customer depositing the money for an agreed term, institutions usually offer higher interest rates than they do on accounts that customers can withdraw from on demand—though 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, interest rates were expected to rise—and 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, financial institutions introduce CDs indexed to the stock market, bond market, or other indices.

Some features of CDs are:

CDs typically require a minimum deposit, and may offer higher rates for larger deposits. The best rates are generally offered on "Jumbo CDs" with minimum deposits of $100,000. Jumbo CDs are commonly bought by large institutional investors, such as banks and pension funds, that are interested in low-risk and stable investment options. Jumbo CDs are also known as negotiable certificates of deposits and come in bearer form. These work like conventional certificate of deposits that lock in the principal amount for a set timeframe and are payable upon maturity. [1]

The consumer who opens a CD may receive a paper certificate, but it is now 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 often no "certificate" as such. Consumers who want a hard copy that verifies their CD purchase may request a paper statement from the bank, or print out their own from the financial institution's online banking service.

Closing a CD

Withdrawals before maturity are usually subject to a substantial penalty. For a five-year CD, this is often the loss of up to twelve 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).

CD refinance

The Truth in Savings Regulation DD requires that insured CDs state, at time of account opening, the penalty for early withdrawal. It is generally accepted that these penalties cannot be revised by the depository prior to maturity.[ citation needed ] However, there have been cases in which a credit union modified its early withdrawal penalty and made it retroactive on existing accounts. [2] The second occurrence happened when Main Street Bank of Texas closed a group of CDs early without full payment of interest. The bank claimed the disclosures allowed them to do so. [3]

The penalty for early withdrawal deters depositors from taking advantage of subsequent better 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. 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 starts by depositing equal amounts of money each into a 3-year CD, 2-year CD, and 1-year CD. From that point on, a CD reaches maturity every year, at which time the investor can re-invest at a 3-year term. After two years of this cycle, the investor has all money deposited at a three-year rate, yet have one-third of the deposits mature every year (which the investor can then reinvest, augment, or withdraw).

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. This can be advantageous, as smaller banks may not offer the longer terms of some larger banks. Although laddering is most common with CDs, investors may use this strategy on any time deposit account with similar terms.

Step-up callable CD

Step-Up Callable CDs are a form of CD where the interest rate increases multiple times prior to maturity of the CD. These CDs are often issued with maturities up to 15 years, with a step-up in interest happening at year 5 and year 10. [4]

Typically, the beginning interest rate is higher than what is available on shorter-maturity CDs, and the rate increases with each step-up period.

These CD’s have a “call” feature which allows the issuer to return the deposit to the investor after a specified period of time, which is usually at least a year. When the CD is called, the investor is given back their deposit and they will no longer receive any future interest payments. [5]

Because of the call feature, interest rate risk is borne by the investor, rather than the issuer. This transfer of risk allows Step-Up Callable CDs to offer a higher interest rate than currently available from non-callable CDs. If prevailing interest rates decline, the issuer will call the CD and re-issue debt at a lower interest rate. If the CD is called before maturity, the investor is faced with reinvestment risk. If prevailing interest rates increase, the issuer will allow the CD to go to maturity. [6]

Deposit insurance

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.

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 lets investors keep up to $50 million invested in CDs managed through one bank with full FDIC insurance. [7] However rates will likely not be the highest available.

Terms and conditions

There are many variations in the terms and conditions for CDs.

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[ citation needed ]; 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.

Criticism

There may be some correlation between CD interest rates and inflation. For example, in one situation interest rates might be 15% and inflation 15%, and in another situation interest rates might be 2% and inflation may be 2%. Of course, these factors cancel out, so the real interest rate, which indicates the maintenance or otherwise of value, is the same in these two examples.

However the real rates of return offered by CDs, as with other fixed interest instruments, can vary a lot. For example, during a credit crunch banks are in dire need of funds, and CD interest rate increases may not track inflation. [10]

The above does not include taxes. [11] 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 is important.

Author Ric Edelman writes: "You don't make any money in bank accounts (in real economic terms), simply because you're not supposed to." [12] On the other hand, he says, bank accounts and CDs are fine for holding cash for a short amount of time.

Even to the extent that CD rates are correlated with inflation, this can only be the expected inflation at the time the CD is bought. The actual inflation will be lower or higher. Locking in the interest rate for a long term may be bad (if inflation goes up) or good (if inflation goes down). For example, in the 1970s, inflation increased higher than it had been, and this was not fully reflected in interest rates. This is particularly important for longer-term notes, where the interest rate is locked in for some time. This gave rise to amusing nicknames for CDs.[ Example? ] A little later, the opposite happened, and inflation declined.

In general, and in common with other fixed interest investments, the economic value of a CD rises when market interest rates fall, and vice versa.

Some banks pay lower than average rates, while others pay higher rates. [13] In the United States, depositors can take advantage of the best FDIC-insured rates without increasing their risk. [14]

As with other types of investment, investors should be suspicious of a CD offering an unusually high rate of return. For example Allen Stanford used fraudulent CDs with high rates to lure people into his Ponzi scheme.

Related Research Articles

Federal Deposit Insurance Corporation US company providing deposit insurance

The Federal Deposit Insurance Corporation (FDIC) is one of two agencies that provide deposit insurance to depositors in U.S. depository institutions, the other being the National Credit Union Administration, which regulates and insures credit unions. The FDIC is a United States government corporation providing deposit insurance to depositors in U.S. commercial banks and savings banks. The FDIC was created by the 1933 Banking Act, enacted during the Great Depression to restore trust in the American banking system. More than one-third of banks failed in the years before the FDIC's creation, and bank runs were common. The insurance limit was initially US$2,500 per ownership category, and this was increased several times over the years. Since the passage of the Dodd–Frank Wall Street Reform and Consumer Protection Act in 2011, the FDIC insures deposits in member banks up to US$250,000 per ownership category.

Bank run Mass withdrawal of money from banks

A bank run occurs when many clients withdraw their money from a bank, because they believe the bank may cease to function in the near future. In other words, it is when, in a fractional-reserve banking system, numerous customers withdraw cash from deposit accounts with a financial institution at the same time because they believe that the financial institution is, or might become, insolvent; they keep the cash or transfer it into other assets, such as government bonds, precious metals or gemstones. When they transfer funds to another institution, it may be characterized as a capital flight. As a bank run progresses, it generates its own momentum: as more people withdraw cash, the likelihood of default increases, triggering further withdrawals. This can destabilize the bank to the point where it runs out of cash and thus faces sudden bankruptcy. To combat a bank run, a bank may limit how much cash each customer may withdraw, suspend withdrawals altogether, or promptly acquire more cash from other banks or from the central bank, besides other measures.

A savings and loan association (S&L), or thrift institution, is a financial institution that specializes in accepting savings deposits and making mortgage and other loans. The terms "S&L" or "thrift" are mainly used in the United States; similar institutions in the United Kingdom, Ireland and some Commonwealth countries include building societies and trustee savings banks. They are often mutually held, meaning that the depositors and borrowers are members with voting rights, and have the ability to direct the financial and managerial goals of the organization like the members of a credit union or the policyholders of a mutual insurance company. While it is possible for an S&L to be a joint-stock company, and even publicly traded, in such instances it is no longer truly a mutual association, and depositors and borrowers no longer have membership rights and managerial control. By law, thrifts can have no more than 20 percent of their lending in commercial loans — their focus on mortgage and consumer loans makes them particularly vulnerable to housing downturns such as the deep one the U.S. experienced in 2007.

The savings and loan crisis of the 1980s and 1990s was the failure of 1,043 out of the 3,234 savings and loan associations (S&Ls) in the United States from 1986 to 1995: the Federal Savings and Loan Insurance Corporation (FSLIC) closed or otherwise resolved 296 institutions from 1986 to 1989 and the Resolution Trust Corporation (RTC) closed or otherwise resolved 747 institutions from 1989 to 1995.

A money market fund is an open-ended mutual fund that invests in short-term debt securities such as US Treasury bills and commercial paper. Money market funds are managed with the goal of maintaining a highly stable asset value through liquid investments, while paying income to investors in the form of dividends. Although they are not insured against loss, actual losses have been quite rare in practice.

A time deposit or term deposit is a deposit in a financial institution with a specific maturity date or a period to maturity, commonly referred to as its “term”. Time deposits differ to at call deposits, such as savings or checking accounts, which can be withdrawn at any time, without any notice or penalty. Deposits that require notice of withdrawal to be given are effectively time deposits, though they do not have a fixed maturity date.

Securities market

Securities market is a component of the wider financial market where securities can be bought and sold between subjects of the economy, on the basis of demand and supply. Securities markets encompasses stock markets, bond markets and derivatives markets where prices can be determined and participants both professional and non professional can meet.

The Massachusetts Depositors Insurance Fund is a deposit insurance scheme that protects depositors at Massachusetts savings banks. It was created in 1934 by the state government of Massachusetts in response to the large number of Massachusetts bank failures during the Great Depression of the 1930s. This fund was the inspiration for the formation of the Federal Deposit Insurance Corporation (FDIC). After the FDIC was created, the state fund was modified to cover all amounts not covered by the FDIC. Typically the FDIC covers the first $250,000; the Massachusetts fund will cover any amount above that. As a result, account holders in Massachusetts savings banks generally have all of their deposits insured by the combination of the state fund and the FDIC.

Deposit insurance is a measure implemented in many countries to protect bank depositors, in full or in part, from losses caused by a bank's inability to pay its debts when due. Deposit insurance systems are one component of a financial system safety net that promotes financial stability.

A money market account (MMA) or money market deposit account (MMDA) is a deposit account that pays interest based on current interest rates in the money markets. The interest rates paid are generally higher than those of savings accounts and transaction accounts; however, some banks will require higher minimum balances in money market accounts to avoid monthly fees and to earn interest.

An investment certificate is an investment product offered by an investment company or brokerage firm designed to offer a competitive yield to an investor with the added safety of their principal.

Diamond–Dybvig model

The Diamond–Dybvig model is an influential model of bank runs and related financial crises. The model shows how banks' mix of illiquid assets and liquid liabilities may give rise to self-fulfilling panics among depositors.

The National Credit Union Share Insurance Fund provides deposit insurance to protect the accounts of credit union members at federally insured institutions in the United States. Created in 1970, the Share Insurance Fund is administered by the National Credit Union Administration, an independent federal financial regulator. The Share Insurance Fund is funded completely by participating credit unions, and not one penny of insured savings has ever been lost by a member of a federally insured credit union. The Share Insurance Fund is backed by the full faith and credit of the United States government.

Bank regulation in the United States is highly fragmented compared with other G10 countries, where most countries have only one bank regulator. In the U.S., banking is regulated at both the federal and state level. Depending on the type of charter a banking organization has and on its organizational structure, it may be subject to numerous federal and state banking regulations. Apart from the bank regulatory agencies the U.S. maintains separate securities, commodities, and insurance regulatory agencies at the federal and state level, unlike Japan and the United Kingdom. Bank examiners are generally employed to supervise banks and to ensure compliance with regulations.

Bank Financial institution that accepts deposits

A bank is a financial institution that accepts deposits and recurring accounts from the people and creates a demand deposit. Lending activities can be performed either directly or indirectly through capital markets. Due to their importance in the financial stability of a country, banks are highly regulated in most countries. Most nations have institutionalized a system known as fractional reserve banking under which banks hold liquid assets equal to only a portion of their current liabilities. In addition to other regulations intended to ensure liquidity, banks are generally subject to minimum capital requirements based on an international set of capital standards, the Basel Accords.

A market-linked CD (MLCD) is also referred to as an equity-linked CD, market-indexed CD or simply an indexed CD as well. It is a specific type of certificate of deposit that is linked to the performance of one or more securities or market indexes, like the S&P 500. Additionally, the term length is usually much longer, with periods ranging over many years rather than several months.

A deposit account is a bank account maintained by a financial institution in which a customer can deposit and withdraw money. Deposit accounts can be savings accounts, current accounts or any of several other types of accounts explained below.

A fixed deposit (FD) is a financial instrument provided by banks or NBFCs which provides investors a higher rate of interest than a regular savings account, until the given maturity date. It may or may not require the creation of a separate account. It is known as a term deposit or time deposit in Canada, Australia, New Zealand, India and The United States, and as a bond in the United Kingdom and For a fixed deposit is that the money cannot be withdrawn from the FD as compared to a recurring deposit or a demand deposit before maturity. Some banks may offer additional services to FD holders such as loans against FD certificates at competitive interest rates. It's important to note that banks may offer lesser interest rates under uncertain economic conditions. The interest rate varies between 4 and 7.50 percent. The tenure of an FD can vary from 7, 15 or 45 days to 1.5 years and can be as high as 10 years. These investments are safer than Post Office Schemes as they are covered by the Deposit Insurance and Credit Guarantee Corporation (DICGC). However, DICGC guarantees amount up to ₹ 100000(about $1555) per depositor per bank. They also offer income tax and wealth tax benefits.

Insured Cash Sweep

The Insured Cash Sweep® or ICS® service is used by banks and savings associations that are insured by the Federal Deposit Insurance Corporation (FDIC). Financial institutions that are in the ICS Network can place the deposits received from their customers into interest-bearing savings accounts at other FDIC-insured banks in the Network.1 Banks can also place their customer funds into demand deposit accounts using the ICS demand option.2 Because the funds are placed at multiple banks across the Network in amounts that stay within the FDIC deposit insurance limit at each bank ($250,000), the customer is eligible for total amounts of deposit insurance that are greater than the standard insurance limit for any one bank.3

Promontory Interfinancial Network, LLC, is a privately held firm with a network of financial institutions that has approximately one-third of all U.S. commercial banks and thrifts as members. The company is located in Arlington, Virginia.

References

  1. Feldler, Alex (2017-06-13). "The Best Jumbo CD Accounts of 2020". MyBankTracker. Retrieved 2020-02-07.
  2. "Fort Knox FCU – Early Withdrawal Penalty". DepositAccounts.
  3. "Main Street Bank closes CDs early". JCDI. 2010-12-30.
  4. "Callable Step-Up Certificates of Deposit Wells Fargo Bank, N.A. Disclosure Statement" (PDF). 2015-10-01. Archived from the original (PDF) on 2017-12-01. Retrieved 2017-11-22.
  5. "What Are Callable Certificates of Deposit (CDs)?". Do It Right. Retrieved 2017-11-22.
  6. "A word of caution regarding 'Step-Up Callable CDs'". Financial Strength Coach. Retrieved 2017-11-22.
  7. "CDARS".
  8. "ING Direct Account Disclosures". Archived from the original on 2012-02-09. Retrieved 31 Jan 2012. Change to/Waiver of Terms: We can add to, delete or make any other changes ("Changes") we want to these terms at any time. You and your account will be bound by the Changes as soon as we implement them. If the Change isn't in your favor, before it's implemented, we'll let you know about it as required by law. However, if applicable law requires us to make a Change, you may not receive any prior notice. We can cancel, change or add products, accounts or services whenever we want. Notice of any such changes, additions or terminations will be provided as required by law. We can waive any of our rights under these Terms whenever we want, but this doesn't mean that we'll waive the same rights in the future.
  9. "Major Bank Certificate of Deposit Renewal Rate Rip-Off". Archived from the original on 2008-07-03.
  10. Goldwasser, Joan (September 10, 2008). "Upside of the Credit Crunch". The Washington Post. Retrieved April 28, 2010.
  11. Ric Edelman, The Truth About Money, 3rd ed., p. 30
  12. Ric Edelman, The Truth About Money, 3rd ed., p. 61
  13. Compare a typical large-bank 1-year CD, e.g., "Wells Fargo". vs the highest 1-year CD available at a listing service, e.g., "BankCD.com".
  14. "FDIC: Insuring Your Deposits". Archived from the original on 2008-09-16.