Updated July 10, 2023
What is a Certificate of Deposit?
The term “certificate of deposit” refers to the money market instrument issued by various banks and other similar financial institutions to raise money from the secondary market.
This financial instrument has a predetermined duration during which the investor can earn a fixed interest rate on their deposit. However, an early withdrawal penalty is imposed on the investor if the deposited funds are withdrawn before the specified maturity date.
Explanation of Certificate of Deposit
Financial institutions offer a fixed interest rate on the deposited amount through a financial product known as a certificate of deposit. However, banks may vary the interest rate when they issue it, which can be issued in physical or dematerialized form. After the expiry of the maturity period, the investor can either withdraw the maturity amount or re-invest it. However, suppose the investor decides to withdraw the principal amount before maturity. In that case, the bank has the right to charge an early withdrawal penalty, the basis and value of which varies across financial institutions.
Features of Certificate of Deposit
Some of the major features of a certificate of deposit are as follows:
- All scheduled commercial banks and financial institutions are eligible to issue certificates of deposit.
- Individuals, trusts, mutual funds, companies, etc, can purchase certificates of deposit.
- Scheduled commercial banks can issue certificates of deposit for 7 days to 1 year, while financial institutions can issue them for 1 year to 3 years.
- A certificate of deposit in the physical form can be transferred via endorsement and delivery, while the dematerialized one can be transferred just like any other dematerialized security.
How Does a Certificate of Deposit Work?
Issuing a certificate of deposit is similar to opening any regular bank deposit account. However, the terms and conditions differ from a regular bank deposit. Now, let us look at the step-by-step guide on how a certificate of deposit works.
- The interest rate is initially locked based on the ongoing market trend and bank rates. However, once it has been fixed, it can’t be changed during the tenure of the deposit.
- The tenure of the deposit is the next important factor in a certificate of deposit. The investor has to be careful as they will be penalized if the principal amount is withdrawn before the expiry of the tenure. However, the investor can collect the maturity amount penalty-free at the end of the tenure/ or maturity date.
- Based on the interest rate and tenure, the investor will decide on the amount of money to be invested in the certificate of deposit.
- The bank or financial institution will then chalk out various terms and conditions of the agreement, such as a penalty to be levied in case of premature withdrawal.
Example of Certificate of Deposit
Let us take the example of David, who invested $8,000 in the certificate of deposit with ABC Bank at a fixed interest rate of 5.5% for seven years. But, first, calculate the redemption value at the end of 7 years.
- Given, Principal amount = $8,000
- Rate of interest = 5.5%
- Tenure = 7 years
Now, the redemption value at the end of 7 years can be calculated as,
- Redemption Value = $8,000 * (1 + 5.5%) 7
- Redemption Value = $11,637.43 ~$11,637
Therefore, the redemption value after seven years will be $11,637.
In the above example, let us assume that David withdraws after five years, and the bank charges 150 days’ interest on the account balance as an early withdrawal penalty. Next, calculate the redemption value at the end of 5 years.
- Given, Principal amount = $8,000
- Rate of interest = 5.5%
- Tenure = 5 years
- Penalty = 150 days’ interest
Now, the account balance at the end of 5 years can be calculated as,
Account Balance = Principal Amount * (1 + Rate of Interest) Tenure
- Account Balance = $8,000 * (1 + 5.5%) 5
- Account Balance = $10,455.68
Now, the penalty fee to be paid for early withdrawal can be calculated as,
Penalty Fee = Account Balance * Penalty / 365 * Rate of Interest
- Penalty Fee = $10,456 * 150 / 365 * 5.5%
- Penalty Fee = $236.33
Now, the redemption value at the end of 5 years can be calculated as,
Redemption Value = Account Balance – Penalty Fee
- Redemption Value = $10,455.68-$236.33
- Redemption Value = $10,219.35 ~ $10,219
Therefore, the redemption value after five years will be $10,219.
Who Should Invest in a Certificate of Deposit?
The following investors should invest in a certificate of deposit:
- Investors who seek a steady and low-risk return
- Individuals and institutions with a long investment horizon
- Investors with an adequate level of liquidity
Certificate of Deposit Rates
The following are certificate of deposit rates offered by some of the banks:
|Sallie Mae Bank CD||0.60%||0.60%||0.60%|
|Marcus by Goldman Sachs High-Yield CD||0.85%||0.85%||0.90%|
|Ally Bank High Yield CD||0.75%||0.75%||1.00%|
|Connexus Credit Union CD||0.61%||0.80%||0.91%|
|Synchrony Bank CD||0.60%||0.75%||0.90%|
|TAB Bank CD||0.60%||0.95%||1.10%|
How to Buy or Sell Certificate of Deposit?
The buying and selling of certificate of deposit take place in the following way:
- First, the seller and the buyer agree on a transaction price.
- The seller then authorizes the depository participant via delivery instructions slip, based on which the certificate of deposit is transferred from the seller’s account to the buyer’s account.
- Both parties can also hire a professional agent for convenience.
Some of the major advantages are as follows:
- It is relatively less risky than other money market instruments, such as corporate bonds, stocks, etc.
- It offers higher returns as compared to traditional bank deposit schemes.
Some of the major disadvantages are as follows:
- Its liquidity is constrained as the money gets blocked for a specific period. However, premature withdrawal is allowed in exchange for the penalty.
- Fixed rate of interest results in a notional loss in a growing interest rate environment.
This is a guide to the Certificate of Deposit. Here we also discuss the introduction and how a certificate of deposit works. Along with advantages and disadvantages. You may also have a look at the following articles to learn more –