What is a Certificate of Deposit (CD)?
A Certificate of Deposit (CD) is a financial product offered by banks and credit unions that allows individuals to earn interest on their savings for a fixed period of time. When a person purchases a CD, they deposit a specific amount of money with the financial institution for a set term, which can range from a few months to several years.
In exchange for the deposit, the financial institution pays the individual a fixed interest rate for the duration of the term. The interest rate is typically higher than the interest rate offered on traditional savings accounts, but is also fixed and cannot be changed for the term of the CD. At the end of the term, the financial institution returns the original deposit, along with any accrued interest, to the individual.
Certificates of Deposit are considered low-risk investments, as they are insured by the Federal Deposit Insurance Corporation (FDIC) for up to $250,000 per depositor, per insured bank. This means that if the bank were to fail, the depositor would still receive their initial deposit, up to the insurance limit.
There are several types of CDs, including traditional CDs, bump-up CDs, and liquid CDs. Traditional CDs offer a fixed interest rate and term, while bump-up CDs allow the depositor to increase the interest rate once during the term. Liquid CDs allow the depositor to withdraw funds before the end of the term, but typically have lower interest rates.
One of the main advantages of Certificates of Deposit is their low risk and predictable returns. They are a good option for individuals who are looking for a safe place to save their money and earn a higher interest rate than traditional savings accounts. Additionally, CDs can be used as collateral for loans, which can provide a lower interest rate on the loan.
However, there are also some disadvantages to CDs. Because the interest rate is fixed, the depositor may miss out on higher returns if interest rates rise during the term of the CD. Additionally, if the depositor needs to withdraw the funds before the end of the term, they may be subject to early withdrawal penalties.
Simplified Example
Think of it like a piggy bank that you can't open for a while, but when you do, you will get extra money in there because you didn't spend it. It's a good way to save money for something specific like a trip or a new item, you know you can't touch it for a certain amount of time and you will be rewarded for it.
History of the Term Certificate of Deposit (CD)
The term "Certificate of Deposit" (CD) dates back to the early 1960s when financial institutions introduced this investment product. Banks in the United States began issuing CDs as a means to attract deposits by offering higher interest rates than regular savings accounts. In 1961, the First National City Bank of New York (now Citibank) is often credited with pioneering the modern CD. These financial instruments allowed customers to deposit funds for a fixed period, ranging from a few months to several years, in return for a predetermined interest rate. The concept quickly gained traction as a low-risk investment vehicle, providing individuals with a secure way to grow their savings over a specified term. CDs continue to be an integral part of the financial landscape, offering investors a stable and predictable means of earning interest on their savings.
Examples
Traditional CDs: A traditional CD is a time deposit with a fixed interest rate and maturity date. The interest rate is typically higher than a savings account and the depositor agrees to keep the funds in the account for a set period of time, which can range from a few months to several years. At the end of the term, the depositor can withdraw the principal and interest or roll it over into a new CD.
Jumbo CDs: A jumbo CD is a certificate of deposit with a high minimum deposit requirement, typically $100,000 or more. Jumbo CDs typically offer higher interest rates than traditional CDs, but they also require a larger initial investment.
Callable CDs: A callable CD is a certificate of deposit that can be redeemed by the issuer before the maturity date. The issuer has the option to "call" the CD and return the principal to the investor before the end of the term, typically in exchange for a lower interest rate. Callable CDs can offer higher interest rates than traditional CDs, but they also carry the risk of early redemption.