What is a 'Certificate Of Deposit - CD'
A certificate of deposit (CD) is a savings certificate with a fixed maturity date, specified fixed interest rate and can be issued in any denomination aside from minimum investment requirements. A CD restricts access to the funds until the maturity date of the investment. CDs are generally issued by commercial banks and are insured by the FDIC up to $250,000 per individual.
BREAKING DOWN 'Certificate Of Deposit - CD'
A certificate of deposit is a promissory note issued by a bank. It is a time deposit that restricts holders from withdrawing funds on demand. A CD is typically issued electronically and may automatically renew upon the maturity of the original CD. When the CD matures, the entire amount of principal as well as interest earned is available for withdrawal.
Early Withdrawal Penalty
Although it is still possible to withdraw money from a CD prior to the maturity date, this action will often incur a penalty. This penalty is referred to as an early withdrawal penalty, and the total dollar amount depends on the length of the CD as well as the issuing institution. Typical early withdrawal penalties are equal to an established amount of interest.
Example of Certificate of Deposit
Assume 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 year's end, 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 3/12 the annual interest earned will be forfeit as the redemption fee.
Types of CDs Available
CDs of less than $100,000 are called small CDs. Some of these CDs will have minimum investment requirements. For example, a financial institution may require at least $1,000 for a CD to be opened.
CDs for more than $100,000 are called large CDs or jumbo CDs. Almost all large CDs, as well as some small CDs, are negotiable. The term of a CD generally ranges from one month to five years.
Theory Behind CDs
CDs operate under the premise that an individual forfeits liquidity for a higher return. Under typical market conditions, long-term CDs have higher interest rates when compared to short-term CDs. There is more uncertainty and risk associated with holding the investment for a long period of time. In addition, because an individual is forgoing the opportunity to utilize the funds for a specific period of time, he is compensated by earning more interest.
Want to know more? Read Certificates of Deposit: Introduction.