A certificate of deposit is a type of investment account that offers a fixed interest rate for a specific time period. CDs are often used as a form of a savings account. The money deposited into a certificate of deposit is locked in for the duration of the term, so it's important to choose a term that aligns with your financial goals.
Certificate of Deposit Definition
A certificate of deposit (CD) is a savings account that holds a fixed amount of money for a fixed period of time, such as six months, one year, or five years, or another term. In exchange, the issuing financial institution pays interest. When someone redeems a CD, or it reaches maturity, they receive the money they originally invested plus interest.
CDs vs. Savings Accounts
Certificates of deposit, or CDs, are a type of savings product that offers a fixed interest rate for a specific time period. However, the funds may be partially or fully locked-in until the maturity date. Savings accounts, on the other hand, are more liquid than CDs, as individuals can access their bank account funds at any time. Savings accounts also typically offer lower interest than CDs.
Term Deposits and Guaranteed Investment Certificates (GICs)
Term Deposits are another name used for Certificates of Deposit. In Canada, financial institutions offer GICs, which stands for Guaranteed Investment Certificates. Canadian GICs are sometimes plain vanilla products, although some products offer increasing rates (similar to "step-up CDs" and varied redemption options. Other GICs may offer a lower guaranteed rate with no risk, but the potential for interest bonuses based on how stock markets perform.
How CDs Work
In the United States, CDs are insured by the Federal Deposit Insurance Corporation (FDIC) up to $250,000 per depositor, per account type, at each bank or credit union. This means that the money in a CD is backed by the full faith and credit of the United States government.
When someone opens a CD account, they agree to keep their money on deposit for a set period of time. Traditionally, the longer the term, the higher the interest rate, but that is not always the case. If an investor withdraws their money before the end of the term, they'll often pay a penalty. Let's take a look at a few more attributes that make up a certificate of deposit:
- Fixed Interest Rate: Many CDs offer a fixed interest rate for the entire term.
- Length of Term: Terms on a CD are typically offered in three-month increments (3 months, 6 months, etc..) up to 1 year and then are offered in 2-year, 3-year, or 5-year terms.
- Withdrawal Penalties: The federal government sets a minimum withdrawal penalty on CDs but not a maximum so the penalty will vary by financial institution offering the CD. The withdrawal penalty is currently 3 months of simple interest, whereas there is no mandatory minimum withdrawal penalty for a savings account.
- Auto Reinvestment: Many CDs will auto reinvest to a CD of the same term at maturity unless they stipulate otherwise. Once it is reinvested investors can't withdraw without paying the penalty.
Note: Canadian GICs are insured by the Canada Deposit Insurance Corporation (CDIC), also up to certain maximums.
CD Rates
Certificates of deposit offer a fixed yield for a specific time period. During that time period, the money will earn interest expressed in an annual percentage yield (APY). The rates offered vary over time, and largely linked to market yields in fixed-income markets, such as U.S. Treasury yields. When interest rates are rising, rates offered by CDs will usually also rise.
When it comes to CD rates, there are a few things to keep in mind.
- Most of the time longer term CDs will offer higher interest rates. This is due to what's know as liquidity preference. If an individual has the option to invest in a 1-year CD for 4%, or a 3-year CD also for 4%, they will usually prefer investing for one year only, and deciding at maturity whether to invest again. So for banks to secure longer-term deposits, they typically offer higher rates for longer-terms.
- CD rates are affected by market conditions and the level of interest rates.
- It's useful to compare CD rates from different banks before choosing one. Banks offer different rates, so it's important to shop around to find the best deal.
CD Taxes
The money earned from a CD is considered taxable investment income, unless the investment is held in a tax-sheltered account.
Important: Be sure to discuss any tax implications with your financial advisor before investing in a CD.
Types of CDs
There are several different types of CDs to choose from, each with its own set of benefits and drawbacks.
- Traditional CDs: a fixed-term account that offers a higher interest rate than a savings account. The money deposited into a traditional CD is locked in for the duration of the term, so it's important to choose a term that aligns with your financial goals.
- No-Penalty CDs: similar to a traditional CD, but it allows an investor to withdraw their money early without incurring a penalty. This type of account may be a good option if you're not sure how long you'll need to keep your money deposited.
- Step-Up CDs: a type of CD that offers increasing interest rates over time. This type of account can be a good option if looking for a higher return on this investment.
- Jumbo CDs: a type of CD that requires a minimum deposit of $100,000. They typically offer higher interest rates than traditional CDs.
Pros & Cons of a CD
Investing in a certificate of deposit has many benefits but there are also a few drawbacks that should be considered before opening one. Let's take a look at the pros and cons that come with a CD.
Pros
- Higher interest rates than a savings account
- The investment principal is guaranteed not to decline in value, and the interest is guaranteed by the issuer
- Even if the bank issuing the CD declared bankruptcy, the CD will have been insured by the FDIC up to $250,000 per account holder.
- Commissions are usually not chargeable.
- CDs can be a great way to save for short-term goals
Cons
- The interest rate on a CD may not keep up with inflation
- Investors may be subject to a penalty if the money is withdrawn before the end of the term
- CDs typically have a minimum deposit requirement but stocks do not.
Investing in CDs vs. Stocks
Stocks are expected to deliver a higher rate of return than a Certificate of Deposit would, however, investing in the stock market comes with risk of loss. It's entirely possible that a stock market investors redeems their investments for a value that was less than the original amount invested.
CD's are guaranteed not to decline in value, and offer a known interest rate, so there are no surprises for the investor. Investors who are seeking investment security first, and/or who may be investing for only a short period of time, often choose Certificates of Deposit.
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
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