What are Certificates of Deposit (CDs)?
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A Certificate of Deposit (CD) is a savings product offered by banks and credit unions where you deposit a fixed amount of money for a specific period, known as the term. In return, the bank pays a fixed interest rate, typically higher than what is offered by regular savings accounts. The term can range from a few months to several years, with longer terms generally offering higher interest rates. Once the term ends, or the CD matures, you can withdraw your initial deposit plus interest.
Certificates of Deposit (CDs) are a safe, low-risk savings tool that offers higher interest rates than traditional savings accounts, with the trade-off being that your funds are locked in for a set period. For individuals looking to grow their savings without the risk of the stock market or those seeking a guaranteed return, CDs offer a solid solution. However, they are best suited for savers who can comfortably lock away their money for a fixed term and do not need immediate access to their funds.
Certificates of Deposit (CDs) are chiefly used in the United States and this article will focus on how they work there. If a bank or other financial institution outside the U.S. offer you Certificates of Deposit, it is very important to research what this entails, since the terms and conditions abroad can be very different from those prevailing in the U.S.
In several other countries, similar solutions are offered but under other names, e.g. Time Deposit or Term Deposit. In Canada, you can use the Guaranteed Investment Certificate (GIC).
Key Features of CDs
- Fixed Interest Rate: CDs offer a guaranteed interest rate that doesn’t change for the duration of the term. This is a key advantage, particularly if interest rates in the market drop during your CD’s term, as your rate remains locked in.
- Term Length: CDs come with various term lengths, usually ranging from as short as 3 months to as long as 10 years. Generally, the longer the term, the higher the interest rate. Short-term CDs tend to offer lower rates but do provide more flexibility if you need access to your funds sooner.
- Penalties for Early Withdrawal: One important condition of a traditional CD is that your money is locked in for the agreed-upon term. If you withdraw money before this CD matures, you will typically face penalties, which might include forfeiting a portion of the interest or even paying a flat fee.
- FDIC or NCUA Insurance: In the United States, CDs are insured by the Federal Deposit Insurance Corporation (FDIC) or National Credit Union Administration (NCUA) up to $250,000 per depositor, per institution. This provides peace of mind, knowing that your funds are protected in the same way as money in an insured savings account if the bank or credit union were to fail. If you purchase CDs outside of the United States, it is important that you research the insurance situation, since it varies from country to country.
Types of CDs
With the traditional type of CD, you invest a lump sum for a fixed term and earn a fixed interest rate. This is the classic and most common type of CD. Several other types have developed, each with their own peculiarities, so it is important to always check the terms and conditions of a CD in advance. Examples of more unusual CDs are the No-Penalty CD, the Bump-Up CD, and the Jumbo CD.
With a No-Penalty CD, you can withdraw funds early without facing penalties. This is good if you want flexibility, but the trade off is that they typically cone with lower interest rates compared to traditional CDs.
With a Bumb-Up CD, you can “bump up” to a higher interest rate if rates rise during the term of your CD. This can be beneficial in rising-rate environments, although the initial rate on bump-up CDs is often lower than for traditional CDs.
The Jumbo CD was designed for individuals who want to invest a large sum of money, typically $100,000 or more. In exchange for the large deposit, jumbo CDs often offer higher interest rates than regular CDs.
Benefits of CDs
- Higher Interest Rates: CDs generally offer higher interest rates than traditional savings accounts because your funds are locked in for a set period. For savers looking for low-risk options, CDs offer a balance of security and return.
- Guaranteed Return: Because the interest rate is fixed, you know exactly how much you’ll earn by the time the CD matures. This makes CDs particularly appealing for people who prefer predictable and guaranteed returns.
- Safe Investment: Your principal is secure and the interest rate is fixed, unlike stocks or bonds where you are never guaranteed a profit and you investment could even lose value.
- Insurance: In the United States, CDs are insured by the FDIC or NCUA, which means you get your money back if ther bank or credit union fails.
- Flexible Term Options: With a wide range of term lengths available, you can choose a CD that fits your financial goals. Whether saving for a down payment in two years or putting money aside for a longer-term goal, CDs offer flexibility in terms.
Drawbacks of CDs
- Limited Access to Funds: One of the main downsides of CDs is the lack of liquidity. Since your money is locked in for a fixed period, you can’t access it without incurring penalties. Breaking a CD before its maturity date typically results in penalties, such as losing several months’ worth of interest, making it important to only commit money that you’re sure you won’t need during the term. This makes CDs less ideal for emergency funds or for those who need regular access to their savings.
- Fixed Interest Rates: While a fixed interest rate is beneficial if market rates fall, it can be a disadvantage if rates rise. If interest rates increase significantly during your CD term, your locked-in rate may result in lower earnings compared to newer CDs with higher rates. The Bump-Up CD was created to address this, but will typically come with a lower initial interest rate.
- Inflation Risk: In periods of high inflation, the interest earned on a CD might not keep up with the increasing cost of living. This can erode the real value of your money over time, especially in long-term CDs
When Should You Consider a CD?
CDs are best for individuals who:
- Have extra cash they won’t need for a certain period.
- Prefer a guaranteed return and are risk-averse.
- Want to lock in current interest rates, especially when they’re higher than usual.
- Are saving for specific short- or long-term goals.
What Is A Guaranteed Investment Certificat (GIC)
The Guaranteed Investment Certificat (GIC) is a Canadian investment with many similarities to the United States Certificat of Deposit (CD). In Frech, it is called Certificat de Placement Garanti (CPG).
The GIC offers a guaranteed rate of return over a fixed period of time. Both banks and trust companies issue GICs in Canada. Which return you will be offered typically vary depending on the length of the term.
When you purchase a GIC, the interest rate is typically higher than what the issuing institution is offfering for basic savings accounts.
To protect investors against firm failures, GICs in Canada is guaranteed by the Canada Deposit Insurance Corporation (CDIC) if the issuing financial institution is a CDIC member and the original term to maturity is five years or less. The guarantee is valid up to a maximum of $100,000 (principal and interest combined).
Market Growth GICs (Stock-Indexed GICs)
For Market Growth GICs, the interest rate is determined by the growth rate for a certain stock market index, such as the TSX. Because of this, they are also known as Stock-Indexed GICs.
This means that there is no guarantee that you will get any interest payments at all. Investing in GICs is a type of index speculation and it is more risky than the traditional GICs. Still, the risk is relatively low, since you can not lose your principal as long as you buy a Market Growth GIC issued by a CDIC member.
While there is no limit for how much the stock market can rise, Market Growth GICs are issued with a cap – a maximum return that can not be exceeded no matter how much the stock index rises. This means that for a CDIC insured Market Growth GIC, the worst case scenario is zero interest rate (but you get your principal back) and the best case scenario is reaching the cap. At the time of writing, the caps are usually placed somewhere in the 7% – 15% per year range, depending on the particular index and the investment length.