What is a 'Term Deposit'
A term deposit is a deposit held at a financial institution that has a fixed term. These are generally short-term with maturities ranging anywhere from a month to a few years. When a term deposit is purchased, the lender (the customer) understands that the money can only be withdrawn after the term has ended or by giving a predetermined number of days notice. These types of financial products are sold by banks, thrift institutions and credit unions.
BREAKING DOWN 'Term Deposit'
Also known as certificates of deposit (CDs), time deposits and "bonds" in England, term deposits are an extremely safe investment and are therefore very appealing to conservative, low-risk investors. Term deposits sold by banks are insured by the Federal Deposit Insurance Corporation and the National Credit Union Administration for credit unions. Term deposits, because they allow banks to hold onto a deposit for a specific amount of time, allow banks to invest in higher gain financial products.
In return, financial institutions are more likely to pay higher interest rates to the lender. Most institutions will offer fixed rates, but it's not unheard of to have a CD with variable rates - one example was in the early 2000's when banks offered CD's that could have their interest rates bumped-up only once, and not lowered. Generally, interest rates should be proportional to the time and amount that the principle is lent to the credit union or bank. A 'jumbo-CD' for instance, (usually over $100,000) will receive much more in interest rates than a $1,000 CD. The smaller the institution, the more likely the interest rate will be higher, and uninsured banks tend to offer the highest rates.
Opening / Closing a Term Deposit / CD
While they're called certificates of deposits, few who open a term deposit actually receive a certificate. Though it used to be the case that a person would receive some form of certificate, usually a term deposit just appears as a book entry in a bank statement. Paper statements can still be requested, where the principal, interest rate, and duration as agreed by the lender and financial institution.
Closing a term deposit before the end of the term, or maturity, comes with the consequence of lost interest on the principal. The penalty for withdrawing prematurely or against the agreement is stated at the time of opening a term deposit, as required by the Truth in Savings Regulation. Sometimes, if the financial environment is right and interest rates have risen a considerable amount, the penalty a financial institution may not be enough of a deterrent for an investor to withdraw their term deposit and refinance it at a higher rate.
When a term deposit is reaching it's maturity date, the financial institution that has been holding the investor's principal will usually send a letter asking for direction on what steps to take. The steps an investor can take are either withdrawing the principal originally invested with the institution, or they can let it roll over. If the holder gives no instruction, the institution can reinvest that money.
One strategy for investing term deposits is to distribute an investment evenly over a set number of years in long-term CDs. This strategy locks in higher interest rates due to the investment in longer term CDs while also making it so a part of the lump investment matures regularly.
For example, if an investor deposits $3,000 in a 5, 4, 3, 2, and 1-year term deposit, each year the investment will reach maturity. This strategy can be used while investing with the same credit union or bank, or across a few different institutions. The investor can either recoup the principal and the interest and keep it, or they can then re-invest in another 5 year term deposit. Financial institutions aren't responsible for the management of a ladder investment strategy, the investor is.
Drawbacks of CD's
On term deposits, interest rates can track inflation rates, making it so any gain on the principal is in fact not a gain in value but simply a gain in capital. However, the issue is not whether or not term deposit track inflation, but how closely they do. This can be to the benefit or disadvantage to the investor. If the projected inflation rate is high, and inflation goes below what is expected and the interest rate on the principal invested is locked in, then the investor stands to gain value on the term deposit. If the inflation rate ends up going higher than anticipated and the interest rate isn't adjusted, an investor could lose value on their investment.
Outside of inflation, term deposits with wildly high interest rates have been used in the past to draw in participants into ponzi schemes.