Certificate of Deposit - Definition
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Certificate Of Deposit (CD) Definition
The certificate of deposit is a financial instrument issued by a financial institution that offers a fixed return in the given period of time (maturity date). Certificates of deposit began to be issued by US commercial banks beginning in 1961. There is a secondary market where this financial security can be exchanged. It allows the investor to sell the securities before maturity, although it is true that the liquidity is less than that of other types of assets (such as stock shares).
A Little More on What is a Certificate of Deposit
CDs are a popular method for creating secured savings. The interest rate is very low because of this security, but there are generally no fees associated with the investment. The CD does not allow the owner to withdraw funds or cash in the CD with paying a penalty. The holder is obligated to leave the money with the bank for the entire term. Most CD terms are between 3 months and 5 years. Because of the risk associated with market uncertainty, the longer-term CDs pay a higher rate of return than short-term CDs. Like bank deposits, CDs are insured by the Federal Deposit Insurance Corporation for up to $250,000. There are numerous types of special CDs with unique characteristics, including:
- Step-Up Certificates of Deposit - This type of CD allows for annual percentage yield increases after pre-determined periods.
- Bump-Up Certificate of Deposit - This type of CD allows the holder to request a higher APY if the bank adjusts its APYs on newly-issued CDs. Generally, the rate can only be bumped up once or twice during the entire term. Because of this benefit, these CDs generally carry a lower APY than fixed-rate CDs.
- Liquid Certificates of Deposit - This type of CD provides the holder with liquidity or the ability to withdraw their funds. That is, the holder can cash in the CD prior to the end of the term without paying a penalty. Because of the increased liquidity, the CD generally pays a lower APY than fixed-rate CDs.
- Jumbo Certificate of Deposit - This is a traditional CD with a very high minimum investment or purchase price. These CDs generally carry a higher APY than non-jumbo CDs.
- Individual Retirement Account Certificate of Deposit - This is a traditional CD that receives favorable tax treatment (tax-deferred growth) because it is held by an Individual Retirement Account.
The negotiation (trading) of certificates of deposit is rare, except in Latin American countries, where it is still a very active business. CD holders often create a ladder to mitigate some of the risk (interest rate risk) associated with investing in long-term CDs. Laddering is the process of investing proportionally in CDs of varied terms. As shorter-term securities mature, they are reinvested in incrementally longer CDs. This allows the holder to continually maintain a staggered CD ownership structure.
References for Certificate of Deposit