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 It is intended that the CD be held until maturity, at which time the money may be withdrawn together with the accrued interest.

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[edit] 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the agreed-on term, institutions usually grant higher interest rates than they do on accounts from which money may be withdrawn on demand, although this may not be the case in an inverted yield curve situation.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.

[edit] How CDs work

The consumer who opens a CD may receive a passbook or paper certificate, but it now 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 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.

[edit] 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 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.

[edit] 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).

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.

[edit] 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.

[edit] Terms and conditions

It is vital that you study the terms and conditions for a CD before purchase.

In the US, 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.

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 documents carry any legal weight.

Check out the institution offering the CD:

  • Various "certificates" may be offered by companies that are not licensed and regulated financial institutions. CDs can also be forged. See external links in this article.
  • In the US, the institution may not be federally insured by the FDIC or NCUA, which perform periodic audits. A few credit unions obtain insurance from private companies, which could fail in a financial crisis. Check that the institution is currently insured at the FDIC or NCUA website.

Check out the terms of the CD:

  • The penalty for early withdrawal—instead of being measured in months of interest—may be calculated to be equal to the institution's current cost of replacing the money.
  • The penalty for early withdrawal may reduce the principal—for example, if principal is withdrawn three months after opening a CD with a six-month penalty.
  • Withdrawals of principal may be at the discretion of the financial institution.
  • The institution may specify that the CD may be "called"—i.e. closed out by the bank or credit union—at any time. Not good on a CD with a high rate.
  • The institution may not commit to sending a notice before automatic rollover at CD maturity.
  • The institution may not allow the customary five- or seven-day grace period before automatically rolling over the CD to a new CD at maturity.
  • Withdrawal of principal below a certain minimum—or any withdrawal of principal at all—may require closure of the entire CD.
  • Any withdrawal of the interest may be limited to the most recent interest payment rather than the accumulated total interest since the CD was opened.
  • A fee may be charged for withdrawals or closure.
  • The CD may start earning interest from the date of deposit or at the start of the next month or quarter.
  • Accumulated interest at the time of withdrawal may be calculated only through the last full month or last full quarter.
  • Institutions generally have the right to delay withdrawals by up to 60 days.
  • If the CD is in a US Individual Retirement Account, a tax penalty is generally charged for withdrawals or closure before the holder reaches a certain age. There are several major exceptions which are explained on the IRS website.

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

[edit] 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.

[edit] 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.

[edit] 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.

[edit] See also

[edit] External links

General:

Check out the institution:

Rates:

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