A certificate of deposit (CD) refers to a financial product that is offered by financial institutions – such as banks and credit unions – that allow customers to earn a certain level of interest on their deposits, and in return, they must leave the deposit untouched for a certain period of time or risk paying a penalty if it is withdrawn early.
Business Model of Banks
Virtually every bank or credit union will offer certificates of deposits or other financial products that are similar to CDs. When you think about the business model of a bank, in the simplest form, it will take deposits from individuals who do not need the money right now. The bank keeps the money secure and lends out a portion of the money to other people who need the funds. In order to entice people to deposit their money, banks will pay a certain level of interest.
The bank makes profits by charging higher interest on money that is lent out than the interest that is paid to depositors. However, banks are obligated to pay back the depositors’ funds whenever they withdraw it. Therefore, there is a risk that many depositors may withdraw their funds simultaneously.
In order to mitigate such a risk, banks are held to a certain reserve ratio or capital ratio. The ratio indicates how much of the banks’ deposits must be held in case of stressful scenarios where many depositors may wish to withdraw their funds at the same time.
The risk can also be mitigated with certificates of deposit because they are held for a fixed period of time, providing greater safety for banks.
How Certificates of Deposit Work
Although every bank offers CDs, each one may offer different terms with their product offerings. For example, banks may offer different levels of interest rates. Generally, the interest rate that a CD offers is higher than a typical savings account or other money market products because they are not allowed to be withdrawn or re-sold.
Opening a CD with a bank is similar to opening any bank deposit account. However, the key distinction is that when you agree to deposit your money in a CD, you will lock in certain factors regarding the deposited funds:
Term, or length of deposit
The interest rate that is offered when the CD is signed becomes locked in over the time period that the CD is designated for. The interest rate usually fluctuates with the interest rates of the market. Since CDs are usually shorter in terms of length, the interest rate that a CD yields is closely related to the interest rate set by the countries’ central banks.
In the U.S, it is called the federal funds rate, which is set by the Federal Reserve. The bank is not able to change the rate if interest rates end up decreasing. On the other hand, the customer must keep the money in the deposit if the interest rate ends up increasing.
The length that is designated for the CD is locked in after being signed. It is the period of time that the funds cannot be withdrawn without incurring a penalty. CDs come in various lengths (6-month CD, 1-year CD, 2-year CD, etc.). The term expires on a maturity date, which represents the earliest date that the funds can be withdrawn without incurring a penalty.
The amount that is agreed to be deposited in the CD is locked in when signed. There is no standard amount of principal, and for each CD, it can vary substantially.
The bank or financial institution that the CD is opened with will determine the agreement details such as the penalties and where the CD funds will be deposited at maturity.
Advantages of CDs
Certificates of deposit are generally thought of as one of the safest types of investments. Firstly, the fixed interest rate locks in the amount of yield that is going to be earned, reducing the volatility of returns for the investor. In addition, the deposit is guaranteed by the bank that issues it.
2. Higher yield than savings accounts
Larger banks are generally backed by governments, so there is very little risk of default. Also, CDs offer a higher yield than most savings accounts or money market accounts, which is beneficial for those who do not need their funds at the present moment but would still like a safe yield from investment.
Disadvantages of CDs
1. Lack of liquidity
Certificates of deposit are characterized by a lack of liquidity since they are locked in for a certain amount of time. Although they can be withdrawn earlier, it comes at a penalty. The penalty makes it very unattractive to withdraw the funds early.
2. Relatively low yield
Although CDs offer a higher yield than savings accounts, there are many other investments and asset classes that offer a higher yield, including most stocks and other types of bonds.