Certificates of deposit

What Is Certificates of Deposit?

A certificate of deposit (CD) is a type of savings account that holds a fixed amount of money for a fixed period of time, and in return, the issuing bank pays interest. When you purchase a CD, you agree to leave your funds untouched for a specified duration, known as the maturity date. In exchange for this commitment, CDs generally offer higher interest rates than traditional savings accounts. As a component of broader investment vehicles, certificates of deposit are considered low-risk, fixed income products. The interest earned on certificates of deposit can be simple or compound interest, depending on the terms.

History and Origin

The concept of deposit accounts that offer a fixed return for a set period has existed in various forms throughout banking history. However, the modern certificate of deposit gained prominence in the United States particularly after the Great Depression. The widespread bank failures during this period severely eroded public confidence in financial institutions, leading to a desperate need for measures to restore trust. In response, the U.S. government established the Federal Deposit Insurance Corporation (FDIC) through the Banking Act of 1933, often referred to as the Glass-Steagall Act.⁵ The FDIC's creation aimed to protect bank depositors, initially insuring deposits up to $2,500. This government backing fundamentally changed the landscape for deposit products like certificates of deposit, making them a safe haven for savers' funds and contributing to the stability of the financial system. The assurance of federal deposit insurance made banks more attractive places to keep money, paving the way for the broad acceptance and growth of CDs as a secure investment.

Key Takeaways

• Certificates of deposit offer a fixed interest rate for a predetermined period, providing predictable returns.
• They are considered low-risk investments, as deposits in FDIC-insured banks are protected up to specific limits.
• CDs have a set maturity date, and early withdrawals typically incur penalties.
• The interest rates on certificates of deposit are generally higher than those of standard savings accounts but lower than higher-risk investments.
• CDs are suitable for investors seeking capital preservation and a guaranteed return over a specific timeframe.

Formula and Calculation

The interest earned on a certificate of deposit can be calculated using the simple interest formula or the compound interest formula, depending on how the interest is applied. Most CDs offer compound interest.

For simple interest, the formula is:
$I = P \times R \times T$
Where:

• ( I ) = Interest earned
• ( P ) = Principal amount (initial deposit)
• ( R ) = Annual interest rate (as a decimal)
• ( T ) = Time in years

For compound interest, where interest is added to the principal periodically:
$A = P \left(1 + \frac{R}{N}\right)^{NT}$
Where:

• ( A ) = Final amount (principal + interest)
• ( P ) = Principal amount (initial deposit)
• ( R ) = Annual interest rate (as a decimal)
• ( N ) = Number of times interest is compounded per year
• ( T ) = Time in years

To find the interest earned, subtract the principal from the final amount: ( I = A - P ).

Interpreting the Certificates of Deposit

Interpreting a certificate of deposit primarily involves understanding its fixed interest rate and maturity date. A higher interest rate generally means a better return for the depositor, while the maturity date dictates how long the funds are committed. The "yield" of a CD, often expressed as the annual percentage yield (APY), provides a standardized way to compare different CD offerings, taking into account the effect of compound interest. Investors consider the prevailing economic conditions and their own financial goals when selecting a CD term and rate. For example, in a rising interest rate environment, a shorter-term CD might be preferred to allow for reinvestment at higher rates later. Conversely, in a falling rate environment, a longer-term CD locks in a potentially higher rate for an extended period.

Hypothetical Example

Imagine Sarah has $10,000 that she wants to save for three years without significant risk. She is considering a certificate of deposit.

She finds a bank offering a 3-year CD with an annual percentage yield (APY) of 2.5%, compounded annually.

Here's how her investment would grow:

• Initial Deposit (Year 0): $10,000
• Year 1:
  • Interest earned: $10,000 * 0.025 = $250
  • New balance: $10,000 + $250 = $10,250
• Year 2:
  • Interest earned: $10,250 * 0.025 = $256.25
  • New balance: $10,250 + $256.25 = $10,506.25
• Year 3:
  • Interest earned: $10,506.25 * 0.025 = $262.66
  • New balance: $10,506.25 + $262.66 = $10,768.91

At the end of three years, Sarah's initial principal of $10,000 would have grown to $10,768.91, earning her $768.91 in interest. This demonstrates the predictable growth and capital preservation offered by certificates of deposit.

Practical Applications

Certificates of deposit are used by individuals and institutions for various financial planning and diversification strategies, primarily due to their low-risk nature and predictable returns. One common application is saving for short-to-medium-term goals, such as a down payment on a house, a child's college education, or a significant purchase within a few years. Since the funds are locked in for a set period, they are less susceptible to short-term market fluctuations compared to equity investments, providing peace of mind for savers.

CDs are also a key component of conservative investment portfolios, offering a safe place to store cash while earning a better yield than a standard savings account or even a money market account. The Federal Deposit Insurance Corporation (FDIC) provides insurance for deposits, including certificates of deposit, at member banks, up to $250,000 per depositor, per FDIC-insured bank, for each account ownership category.⁴ This insurance makes CDs a highly secure option for preserving capital. The Federal Reserve's monetary policy, which influences benchmark interest rates, directly impacts the rates offered on certificates of deposit, influencing their attractiveness to savers.³

Limitations and Criticisms

While certificates of deposit offer stability and guaranteed returns, they come with certain limitations. One significant drawback is their relative illiquidity. Funds deposited in a CD are typically locked in until the maturity date, and withdrawing money before this time usually incurs an early withdrawal penalty, which can offset a portion of the earned interest or even reduce the principal. This lack of immediate liquidity means CDs are not ideal for emergency funds or money that might be needed unexpectedly.

Another criticism centers on their return potential. In periods of low interest rates, the returns on certificates of deposit may be modest, sometimes barely keeping pace with inflation. This can lead to a real loss in purchasing power over time. For example, a Reuters article noted the "pain for savers" from low global interest rates, highlighting how fixed-income investments like CDs may offer limited returns in such environments.² Unlike investments in stocks or mutual funds, certificates of deposit do not offer capital appreciation potential, meaning their value only grows by the accrued interest. The fixed nature of CD rates also means that if interest rates rise significantly after a CD is purchased, the investor misses out on the opportunity to earn higher returns until their current CD matures, demonstrating a form of opportunity cost.

Certificates of Deposit vs. Savings Account

Certificates of deposit and savings accounts are both types of deposit accounts offered by banks, but they differ significantly in their structure, flexibility, and earning potential. A savings account offers high liquidity, allowing depositors to access their funds at any time without penalty, typically with unlimited transactions (though some regulations might limit certain types of withdrawals). The interest rates on savings accounts are variable and generally lower than those offered by certificates of deposit, reflecting their flexibility.

In contrast, a certificate of deposit requires funds to be held for a fixed term, ranging from a few months to several years, with a specific maturity date. In exchange for this commitment, CDs typically offer higher and fixed interest rates, providing a predictable return. However, withdrawing funds before the maturity date usually incurs an early withdrawal penalty. While both are generally FDIC-insured, CDs are better suited for money that won't be needed for a specific period, whereas savings accounts are ideal for accessible emergency funds or short-term savings goals.

FAQs

Are certificates of deposit safe?

Yes, certificates of deposit are considered very safe. Deposits in FDIC-insured banks, including CDs, are protected up to $250,000 per depositor, per bank, for each account ownership category. This means that even if the bank fails, your insured funds are protected.¹

Can I lose money with a certificate of deposit?

It is highly unlikely to lose your initial principal in a certificate of deposit if it is held in an FDIC-insured bank and you do not withdraw the funds before the maturity date. However, an early withdrawal penalty can reduce your interest earnings or even a portion of your principal if you break the CD term.

How do I choose the right certificate of deposit?

Choosing the right certificate of deposit depends on your financial goals and liquidity needs. Consider the interest rate, the length of the term (maturity date), and any early withdrawal penalty. If you anticipate needing funds sooner, a shorter-term CD or a CD laddering strategy might be more suitable. Compare annual percentage yields (APYs) across different banks to find the most competitive rates.

What is a CD ladder?

A CD ladder is an investment strategy where you divide a lump sum of money into several certificates of deposit with staggered maturity dates. For example, instead of putting all your money into one 5-year CD, you might buy five CDs that mature in 1, 2, 3, 4, and 5 years. As each short-term CD matures, you can reinvest the money into a new longer-term CD, potentially capturing higher long-term interest rates while maintaining some liquidity as CDs mature periodically.