What is a Certificate of Deposit (CD)?

Published by Thomas Herold in Banking, Investments

'Certificate of Deposit (CD)' is explained in detail and with examples in the Investments edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.

A Certificate of Deposit refers to a kind of savings vehicle which generally provides greater returns for money invested than the typical savings accounts do. There is very little risk in such an account. They also come without monthly fees. Besides this, these CDs prove to be significantly different from the age old savings accounts for several reasons.

Such a Certificate of Deposit stands for a time deposit. While an individual who has a savings account is freely able to make additional deposits or withdraw available funds relatively at will, this is not the case with CDs. Holders of CDs consent to tying up their money for a minimum length of time. Banks calls this the term length. Such term lengths might be only a few days. They could also extend up to ten years out. Standard CD’s run from typically three months to five years.

In general, the longer the term length proves to be, the better the rate of interest the Certificate of Deposit will pay. The longer the term length is, the greater amount of time an individual ties up the money in the account at the bank too. It makes sense that the bank rewards customers for committing to a longer amount of time with a larger CD rate than they pay on comparable savings accounts.

Banks generally quote these CD rates using the APY annual percentage yield. This rate takes into account the compounding periods on how often the CD pays interest which can then earn still more interest on it. The banks have the choice of compounding periods based on annually, quarterly, monthly, and daily compounding. The closer a CD compounds to a daily rate, the higher the APY will actually prove to be.

There are penalties involved with drawing the money out of the certificate of deposit before its final maturity date. While every bank is different, most banks will levy a penalty of from three to six months in accrued interest for breaking the time deposit early. This is why financial professionals will counsel against taking money out of a CD early unless it is desperately important to access the funds.

The U.S. FDIC Federal Deposit Insurance Corporation backs the CDs at the overwhelming majority of commercial banks in the country. These Certificates of Deposit are government guaranteed in amounts of up to $250,000. With the credit union CDs, these certificates become insured by the NCUA National Credit Union Administration for the same maximum amounts. Credit unions which are state-chartered will often utilize private insurance for their CDs. Not any of these forms of insurance cover the penalties for taking out the funds ahead of maturity. Such coverage comes automatically and does not have to be applied for in order for the time deposit to be insured.

There are several different varieties of Certificates of Deposit available. Variable rate CDs are those whose interest rate is connected to the prime interest rate, market indices, Treasury bills rates, or another underlying benchmark. They help depositors to gain from any future point interest rate increases. Callable CDs often include a better rate of interest than a traditional CD. The bank can unilaterally reduce the maturity term period on demand though.

No or low penalty CDs pay lower interest rates but allow investors to more easily obtain their money back from the time deposit without expensive penalties. They often require holders to keep a certain minimum balance in the CD. IRA CDs are traditional certificates of deposit which are contained within an IRA Individual Retirement Account. There are tax advantages and deferrals on taxes of interest payments with these. Finally, Jumbo CDs pay greater rates of interest in exchange for extremely high minimum balances of typically $100,000 and higher.

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The term 'Certificate of Deposit (CD)' is included in the Investments edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.