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Certificate of deposit

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This article is specific to the United States. For a more general article, see Time deposit.
A certificate of deposit or CD is, in the United States, a time deposit, a familiar financial product, commonly offered to consumers by banks, thrift institutions, and credit unions.

Such CDs are similar to savings accounts in being insured—by the FDIC for banks or by the NCUA for credit unions—and thus virtually risk-free; they are "money in the bank." 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 It is intended that the CD be held until maturity, at which time the money may be withdrawn together with the accrued interest.

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CD 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the agreed-on term, institutions usually grant higher interest rates than they do on accounts from which money may be withdrawn on demand. For example, as of 2006 one well-known bank offers 0.75% annual interest on savings accounts from which withdrawals may be made on demand, 2% on a 3-month CD, and 4.5% on a 2-year CD.

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.

A few general rules of thumb for interest rates are: 



How CDs work


The consumer who opens a CD may receive a passbook or paper certificate, but as of 2004 it is common for 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 can specify at the time the CD is opened to not "roll over" the CD). 


CDs typically require a minimum deposit of at least $1,000 US, and may offer higher rates for larger deposits.  The best rates are offered on "Jumbo CD's" 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 $99,000).


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 major 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 can not 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 insufficent 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.



CD 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 three 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).   


It should be noted that 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 CD's, this strategy may be employed on any time deposit account with similar terms.



CD 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.  Basic Coverage is $100,000 for a single account and $200,000 for a joint account.  As of April 1, 2006, IRA 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.



CD terms and conditions


By law, 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. The purchaser should read the terms very carefully before buying a CD. Employees of the institution are generally not familiar with this information.  


It is vital that you study the Truth in Savings booklet. A few institutions have it online; all are required to make it available to you before you deposit money. Go into the branch and get one or ask them to mail you a copy. Take it home to study and mark it up. While the booklet is at first overwhelming due to the length and tiny type, the portion of the booklet covering the terms specific to CDs is only one page.


Do not rely on verbal answers to these vital questions; only the booklet carries any legal weight.


Some of the major variations in the terms of CDs include:




If any of these conditions apply, they must be disclosed in the Truth in Savings booklet.



Other CDs and CD-related financial 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, and there are various CD and CD-backed products offered by investment houses and "CD brokers." These are more complicated, and the purchaser needs to research and carefully understand the terms and conditions that apply.



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.



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