What is a Term Deposit
A term deposit is a fixed-term deposit held at a financial institution. They are generally short-term deposits with maturities ranging anywhere from a month to a few years. When a term deposit is purchased, the client understands that the money can only be withdrawn after the term has ended or by giving a predetermined number of days notice.
BREAKING DOWN Term Deposit
When an account holder makes a deposit at a bank, s/he is, in effect, providing the bank with funds which are used to loan borrowers. In return, the bank pays interest to the customer as compensation for allowing it to loan the deposited money to other bank clients. However, with most bank accounts, the account holder can withdraw his or her money at any time. To ensure that it has the funds for a fixed period of time, the bank can issue a type of financial product known as a term deposit.
Term deposits are funds that are locked in for a specified time period, during which the bank invests in financial products with higher returns. For example, a lender may offer a 2% rate for term deposits. The funds deposited are then structured as loans to borrowers who are charged 7% in interest. This means that the bank makes a net 5% return on the term deposits.
In return, financial institutions are more likely to pay higher interest rates to the lender or investor, especially if the interest rate in the economy is high. In periods of rising interest rates, consumers are more likely to purchase term deposits since the increased cost of borrowing makes savings more attractive. When interest rates decrease, consumers are encouraged to borrow and spend more, thereby, stimulating the economy. In this case, interest rates for savings vehicles, such as term deposits, will go down, making them unfavorable investment portals.
Most institutions will offer fixed rates, but it's not unheard of to have a term deposit with variable rates - one example was in the early 2000's when banks offered term deposits 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 (usually over $100,000) for instance, 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. In addition, uninsured banks tend to offer the highest rates.
Term deposits are an extremely safe investment and are therefore very appealing to conservative, low-risk investors. The financial instruments are sold by banks, thrift institutions, and credit unions. Term deposits sold by banks are insured by the Federal Deposit Insurance Corporation (FDIC) and the National Credit Union Administration (NCUA) for credit unions.
Opening or Closing a Term Deposit
Although term deposits are also called certificates of deposits, only few who open a term deposit actually receive a certificate. It used to be the case that a person would receive some form of certificate; now, 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 are included in the statement.
Closing a term deposit before the end of the term, or maturity, comes with the consequence of losing 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 Act. Sometimes, if the financial environment is right and interest rates have risen a considerable amount, the penalty of an early withdrawal may not be enough of a deterrent for an investor who chooses to withdraw his term deposit and refinance it at a higher rate.
When a term deposit is reaching its 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 advising the bank to roll it over to a new term deposit. If the holder gives no instruction, the institution may reinvest the 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 structuring it in a way that a part of the lump sum 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 s/he can 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 Term Deposits
On term deposits, interest rates can track inflation rates, and 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 deposits track inflation, but how closely they do. This can be to the benefit or disadvantage of 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 investors to ponzi schemes.