How Does a Certificate of Deposit Work?

A certificate of deposit or CD is a financial instrument that is offered to consumers by banks, credit unions, and thrift institutions. CDs are time horizoned investments that they are insured up to the FDIC of NCUA limits. Many consider CDs as risk free with no downside.

These fixed term investments (usually of three months, six months, or one to five years) are mainly accompanied by a fixed interest rate. The certificate of deposits are meant to be held until maturity at which time your funds are distributed with accrued interest.

Certificate of deposit rates vary with the time period you purchase the CD. For example, in bad economic times, between 1980 – 1983 the certificate of deposit interest rates reached into the double digits, such as 10%, 12%, 13%, etc; while in good economic times between 1993 – 1999 CD rates fluctuated 3%, 4%, 5%, 6%, etc.

As you can see the interest rates for CDs vary according to the purchase time. Also the certificate of deposit rate varies with the term you choose, the longer the term of a certificate of deposit the higher your interest rate.

While fixed rates are common, some financial institutions offer certificate of deposit interest that is variable. For example, credit unions and banks offer a “bump-up” feature which allows for a onetime interest rate readjustment at the consumer’s choosing, during the CDs term.

Here are the basic certificate deposit interest rate guidelines:

• larger deposit get superior interest rates

• longer term CD get superior interest rates, depends on the current yield curve

• smaller financial institutions usually offer bigger interest rates than larger institutions

• consumer personal certificate of deposit accounts receive higher interest rates than business CD accounts

• credit unions and banks CD accounts uninsured by the NCUA or FDIC offer higher interest rates

Certificate of Deposit Purchase
Banks usually offer certificate of deposits that require a minimum deposit. Best certificate of deposit rates are reserved for larger deposits, such as “Jumbo CDs” with minimum deposits of $100,000. Nevertheless, there are some financial institutions that offer lower interest rates for their Jumbo CDs.

Once a CD is opened and tracked in book entry form, a consumer’s periodic bank statement reflects the regular CD balance.

If you close or access withdrawals before the CDs maturity, a penalty has to be paid. The penalty often includes the loss of several months of certificate of deposit interest. The penalties are in place to prevent consumers accessing their funds before the CDs maturity.

Today, banks, credit union, and other institutions automatically renew the term of the certificate of deposit at maturity unless directed otherwise by you. The act of renewing the CD at maturity is called a “Roll Over CD.”

The CDs are protected as governed by insurance policies of the FDIC and NCUA. The FDIC and NCUA insure customer deposits at member institutions. Presently, single accounts are covered for $250,000 and $500,000 for a joint account. Each account at a different financial institution (not a different branch of the same institution) is insured to the limit.

CDs are mostly chosen by risk adverse investors who want conservative growth and safety of principal. However, certificate of deposit interest rates closely track inflation. For it is, if the inflation rate is 20%, the CD rate may be 20% and if the inflation rate is 5%, the CD rate may be 5%.

Basically, consumers who invest in certificate of deposits are really earning nothing because they are not even beating inflation. Consumers are actually receiving negative returns because they pay taxes on the earnings.

Unfortunately, CD investors misinterpret the CD interest as an increase in value. Herein, certificate of deposits should be an avoidable investment.