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CERTIFICATE
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WHAT IS A CERTIFICATE OF
DEPOSIT (CD) ?
A certificate of deposit or CD is a time deposit, a financial product
commonly offered to consumers by banks, thrift institutions, and
credit unions. Such CDs are similar to savings accounts in that
they are insured and thus virtually risk-free; they are "money in
the bank" (CDs are insured by the FDIC for banks or by the NCUA
for credit unions). 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the money may be withdrawn together with the accrued interest.
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than they do on accounts from which money may be withdrawn on demand,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 that are indexed to the stock
market, the bond market, or other indices are introduced.
A few general guidelines for
interest rates are:
* A larger principal should receive a higher interest
rate, but may not.
* A longer term may or may not receive a higher interest rate, depending
on the current yield curve.
* Smaller institutions tend to offer higher interest rates than
larger ones.
* Personal CD accounts generally receive higher interest rates than
business CD accounts.
* Banks and credit unions that are not insured by the FDIC or NCUA
generally offer higher interest rates.
Buying a 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". The consumer who opens a CD may
receive a passbook or paper certificate, but it now is common for
a 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.
Interest Payout
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.
Closing a CD
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 he has
another investment with significantly higher return or has a serious
need for the money. 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 not to "roll over" the CD).
CD refinance
In the U.S. insured CDs are required by the Truth in Savings Regulation
DD to state at the time of account opening the penalty for early
withdrawal. These penalties cannot 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.
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 two 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.
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. A program called the "Certificate
of Deposit Account Registry Service" allows investors to keep up
to $50 million invested in CDs managed through one bank with full
FDIC insurance.
Terms and conditions
There are many variations in the terms and conditions for CDs. 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. Employees of the institution are
generally not familiar with this information; only the written document
carries legal weight. If the original issuing institution has merged
with another institution, or if the CD is closed early by the purchaser,
or there is some other issue, the purchaser will need to refer to
the terms and conditions document to ensure that the withdrawal
is processed following the original terms of the contract.
Key terms and conditions of
a certificate of deposit include:
* The CD may be "callable." The terms may state
that the bank or credit union can close the CD before the term ends.
* Payment of interest. Interest may be paid out as it is accrued
or it may accumulate in the CD.
* Interest calculation. The CD may start earning interest from the
date of deposit or from the start of the next month or quarter.
* Right to delay withdrawals. Institutions generally have the right
to delay withdrawals for a specified period to stop a bank run.
* Withdrawal of principal. May be at the discretion of the financial
institution. Withdrawal of principal below a certain minimum—or
any withdrawal of principal at all—may require closure of the entire
CD. A US Individual Retirement Account CD may allow withdrawal of
IRA Required Minimum Distributions without a withdrawal penalty.
* Withdrawal of interest. May be limited to the most recent interest
payment or allow for withdrawal of accumulated total interest since
the CD was opened. Interest may be calculated to date of withdrawal
or through the end of the last month or last quarter.
* Penalty for early withdrawal. May be measured in months of interest,
may be calculated to be equal to the institution's current cost
of replacing the money, or may use another formula. May or may not
reduce the principal—for example, if principal is withdrawn three
months after opening a CD with a six-month penalty.
* Fees. A fee may be specified for withdrawal or closure or for
providing a certified check.
* Automatic renewal. The institution may or may not commit to sending
a notice before automatic rollover at CD maturity. The institution
may specify a grace period before automatically rolling over the
CD to a new CD at maturity.
Other similar 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.
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.
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.
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