Certificate of Deposit (CD)

A certificate of deposit (CD) is a cash investment product. It is similar to a savings account with the restriction that money cannot be added or withdrawn after the initial investment. Also known as a time deposit, a CD is money that is invested for a fixed period. When the fixed period ends, the initial investment along with the accrued interest is returned to the investor or reinvested in another CD.

CDs can be purchased from a bank, credit union, investment broker, or brokerage firm. An individual can purchase a CD for any amount of money, although financial institutions and brokerages may require a minimum amount such as $500. In general, the higher the amount invested, the higher the interest rate. The length of time money remains in a CD before it matures varies from thirty days to several years. CDs with longer terms typically pay a higher interest rate than short-term CDs.

Background

An individual purchases a CD by giving money to a bank, credit union, or broker for a specific time period. In return, the CD issuer agrees to pay interest for the use of the money during this period. Unlike a savings account, the individual cannot withdraw this money prior to the CD’s maturity date. Because the CD issuer has a guaranteed period when it can invest this money, it pays a slightly higher interest rate than for a savings account.

When the period ends, the CD matures. The CD issuer notifies the CD holder prior to the maturity date and gives the CD holder the option to receive the initial investment and the accrued interest or to reinvest the cash by renewing the CD or rolling it over to a new CD.

CDs invested with a bank are insured by the Federal Deposit Insurance Corporation (FDIC). Similarly, the National Credit Union Administration (NCUA) insures CDs purchased from a federally insured credit union. Both organizations insure up to $250,000 per financial institution.

The terms of CDs vary widely. Two factors that define a CD are its maturity date and its interest rate. The maturity date is the date when the CD terminates, and the date when the money is available to be returned to the investor. Short-term CDs require a minimal amount of time before the CD matures, such as three or six months. Long-term CDs typically require investments that do not mature for as much as five or ten years.

CDs may pay a fixed or variable interest rate. A fixed rate remains the same throughout the term of the CD, while a variable rate changes as the term goes on. The rate may increase or decrease according to a predetermined schedule or based on the performance of a particular market index.

Banks vary on how interest accrues on a CD and how they pay money upon the CD’s maturity. They may pay by check or electronic transfer of funds. If the money is not withdrawn when the CD matures, some banks automatically renew a CD at the same rate as the original investment. Others apply the current interest rate at the time of renewal.

CDs issuers also vary on early termination policies. Most variable-rate CDs linked to a market indicator cannot be terminated early. Fixed-rate CDs may allow early termination but typically charge a fee or require forfeiture of all or a portion of the interest earned.

CD issuers may include special terms such as a call feature, especially if the CD is long-term and high-interest. This provision allows a bank to cancel the CD at any time. Banks are likely to use this feature when the interest rates go down and are lower than the rate of the CD. For example, if a five-year CD has an interest rate of 3.0 percent and the interest rate goes down to 0.5 percent, the CD issuer may call back the CD rather than pay a rate higher than the current interest rate.

Overview

CDs are low-risk and safe investments. When purchased from an FDIC or NCUA institution, the money in a CD is insured. There is no possibility of losing money as long as the CD is not terminated early. Because CDs can be purchased with a relatively small cash outlay, they provide investment opportunities to individuals who lack large financial assets.

While CDs have lower risks than many other types of investments, such as stocks and annuities, they also have significantly lower returns. CDs offer investors slightly higher interest rates than a savings or checking account, but much lower returns than stocks or most other financial products.

Another disadvantage is that an investor does not have access to the money for the term of the CD. The money in a fixed-rate CD cannot be withdrawn without a penalty. If an investor does withdraw the money prior to the CD’s maturity, the fee may be higher than the CD’s accrued interest, resulting in a loss of the initial investment. Similarly, if interest rates go up, the CD will earn less than if it could be withdrawn and invested in a higher-rate CD.

CDs are often beneficial to individuals who want to invest money for a short period of time or for a specific purpose, such as purchasing a house or car. The money is set aside, helping the investors save, and it earns a small amount of interest. Individuals who desire greater gains, such as for building up a retirement fund, will need to invest in other financial products that have a higher return.

The U.S. Securities and Exchange Commission reports that many consumer complaints about CDs are a result of the buyer’s failure to understand the CD’s terms. It recommends that potential buyers make sure they understand when the CD matures and read the fine print of the CD agreement, disclosure statement, and other financial documents. Prospective CD buyers should not only read these documents, but confirm understanding of the language used in them. The language used in many financial documents is complex and may have a less obvious meaning. For example, a one-year non-callable CD is a CD that cannot be called during the first year, not a CD that matures at one year. Investors should check to see if the policy has a call feature, and verify the difference between the CD’s duration and call period.

Prospective buyers should also make sure that the CD meets their needs. When purchasing long-term CDs, the buyer needs to weigh the advantages against the loss of access to the money for the CD’s term and determine if the gains are greater than potential losses. It also helps to pay attention to interest rates and determine whether they are increasing or decreasing. If they are increasing, or if the U.S. Federal Reserve has made announcements that indicate a near-future increase in the federal funds rate, delaying the CD purchase may result in a higher interest rate. Another useful strategy when interest rates are low is to choose short-term CDs over those with higher returns. When those CDs mature, they can be reinvested in new CDs with higher rates if the interest rates do increase.

Other strategies include laddering, bulleting, and the barbell method. Laddering involves spreading out an investment by purchasing multiple CDs with different maturity dates. The long-term CD has the highest interest rate, while the short-term CDs have lower interest rates. When the short-term CDs mature, they can be reinvested at a longer term if the rates have gone up. Investors can stagger the CDs so one matures each year, giving them the opportunity to cash in a CD and access money at regular intervals.

Bulleting involves purchasing a long-term CD for a specific purpose, such as a house. As more money becomes available for investment, shorter-term CDs can be purchased to mature on the same date.

The barbell method is similar to the laddering method. It involves purchasing multiple CDs with different maturity dates. Unlike laddering, though, it does not seek to stagger CDs to mature at specific intervals. Instead, money is invested in a long-term CD and several short-term CDs. When the short-term CDs mature, they are invested in a long-term CD if the interest rates have gone up. If not, they are reinvested in short-term CDs until the rates increase. This strategy is popular among investors with large amounts of money to invest who have less need to access cash in the near future.

Because no licensing is required of CD brokers, it is important to check the credentials of a broker before purchasing a CD. In addition, prospective buyers should find out the bank the broker is buying the CD from to make sure it is FDIC insured and to confirm that the amount of money in the CD and other savings and checking accounts will not exceed the $250,000 amount that the FDIC insures for this type of account for each bank.

Bibliography

"Certificates of Deposit: Tips for Investors." NEA Member Benefits Corp, www.neamb.com/personal-finance/certificates-of-deposit-tips-for-investors. Accessed 4 Dec. 2024.

Pilon, Mary. "What Is a Certificate of Deposit (CD)?" Wall Street Journal, 18 Nov. 2018, www.wsj.com/articles/what-is-certificate-of-deposit. Accessed 4 Dec. 2024.

“Shopping for a Certificate of Deposit?” FDIC, Nov. 2023, www.fdic.gov/consumer-resource-center/2023-11/shopping-certificate-deposit. Accessed 4 Dec. 2024.

Smith, Lisa. "Certificates of Deposit." Investopedia, www.investopedia.com/certificate-of-deposits-4689733. Accessed 4 Dec. 2024.

Tierney, Spencer. “How to Invest in CDs: 3 Strategies.” NerdWallet, 1 May 2024, www.nerdwallet.com/article/banking/how-to-invest-in-cds. Accessed 4 Dec. 2024.

U.S. Securities and Exchange Commission. "High-Yield CDs: Protect Your Money by Checking the Fine Print." SEC Office of Investor Education and Advocacy, 2 Dec. 2008, www.sec.gov/about/reports-publications/investorpubscertifichtm. Accessed 4 Dec. 2024.