A certificate of deposit (CD) is a time deposit with a bank. CDs are generally issued directly by commercial banks, but they can be purchased via brokerage firms. CDs have a specific maturity date (from three months to five years), a stated interest rate, and can be issued in any denomination, much like bonds. Most CDs assess a penalty for early withdrawal prior to the CD’s date of maturity.
Certificates of deposits are offered by banks and as such are covered by FDIC insurance just like a savings or checking account. As long as the value of the CD is under the FDIC limits of $250,000 per depositor per bank, your CD will be covered.
Fixed rate and term
Most CDs have a fixed interest rate and a fixed time until maturity. Upon maturity account holders receive the face amount of the CD plus any unpaid interest.
Here is an example of how a CD works:
An investor purchases a $10,000 CD with an interest rate of 2% compounded annually and a term of two years. The CD comes with an early withdrawal penalty of three months of interest. At the end of the first year, the CD will have grown to $10,200 ($10,000 * 1.02). At the end of the second year, the CD will have grown to $10,404 ($10,200 * 1.02). If the CD is liquidated before the maturity date, an early withdrawal penalty of 3 months would equate to about $50. Assuming the CD is held to maturity, the holder would receive the full value of $10,404.
Most, but not all, CDs require you to hold the CD until the end of the term. If you cash out early there is generally a penalty, typically three month’s worth of interest.
CD rates are quoted as an annual percentage yield (APY). There are a number of sites that list top CD rates nationally and by region/location so consumers can shop to find a CD with the best rates and terms for their needs.
The frequency of interest payments will vary and banks can choose daily, monthly, quarterly or annual compounding. The frequency of compounding will impact the annual percentage rate (APR,) a measure of the actual return when compound interest is taken into account.
Types of CDs
Beyond the plain-vanilla CDs, there are a number of varieties that include:
· Variable rate CDs where the interest is tied to the prime rate, the T-Bill rate or some other indicator. In a rising rate environment, account holders can benefit from increased rates, though the opposite can happen as well.
· Liquid CDs that allow for early withdrawal. In exchange for this liquidity feature the interest rate may be a bit lower.
· Callable CDs allow the bank to call in or redeem the CD if paying the interest rate becomes a bad deal for them. This might occur in a period of decreasing interest rates. To compensate customers, the interest rate will be a bit higher than for similar CDs without this feature.
· Jumbo CDs have a higher minimum deposit ($100,000 or more is common) and in exchange they pay higher rates of interest.
· Brokered CDs are issued by banks but bought and sold through brokerage firms. The CD holder receives full principal and any interest due if the CD is held to maturity, but can sell the CD through the broker if desired without penalty.