Certificate of Deposit (CD) For Risk Adverse Investors?

A certificate of deposit (CD) is a financial product that allows a financial institution or brokerage firm (typically banks and credit unions) to hold a depositor’s funds until a fixed maturity date in exchange for a fixed rate of return. The essential trade-off is that the buyer of the CD is sacrificing liquidity (i.e. access to their money) for the guarantee of a return of their principal plus all the interest earned at the time of maturity.

This brings to mind two important characteristics of CDs. First, in virtually all cases, the deposits (up to $250,000) have deposit insurance from the FDIC which means, unlike a money market fund, there is no chance of an investor losing their principal balance. Second, because investors are allowing their funds to be tied up for a specific period of time, certificates of deposit will offer competitive interest rates that are higher than the rates found in a traditional savings account or money market account.

One way to think about CDs is that they are, in essence, a promissory note between the seller and the buyer. As the buyer, you are allowing the financial institution to borrow your money for a fixed period of time, known as the maturity period. In return, they are offering you a higher rate of interest on that money.

For their part, banks are eager to sell CDs because they rely on deposits to fund their lending operations. Certificates of deposit provide them with a form of cost certainty because they know they will have those funds until the maturity period ends.

Certificates of deposit are considered small or large depending on the amount invested in them. A small CD is considered one that has a value (initial deposit) of less than $100,000. These CDs will generally require a minimum investment to open. This is generally $500 or $1,000. A large, sometimes called a jumbo CD, is one that has a value (initial deposit) of more than $100,000. These are usually considered negotiable (see below) and have shorter lengths to maturity.

All interest rates advertised for a CD are based on an annual percentage rate. So a CD paying 3% would mean that an investor who puts $1,000 into a one-year CD would receive $1,000 plus the 3% interest at the end of the first year. Since the interest earned on a certificate of deposit is compound interest, the value of the CD at maturity would depend on how frequently the interest was compounded. Most CDs will compound interest daily or monthly.  This can make a significant difference in the value of the CD at maturity.

Assuming an investor purchased a 12-month $2,000 CD with a 2% interest rate that compounded monthly, the value of the CD would look like this:

If the investor were to put their money into a product that paid simple interest at maturity the value would be an even $2,040. This starts to show the benefit of compound interest. If the CD were compounded daily, the amount would be higher. You can also see that if the CD was held for five years, the investor would receive even more benefits from compound interest. This is also because lenders will pay out a higher fixed interest rate in return for a longer maturity length.

One of the downsides of owning a CD is that the owner of the CD will have to pay federal and state taxes on the interest that accrues in the CD. The one exception is if they own an IRA CD (explained below). In our example above, assuming the investor purchased the CD in January and it reached in December, they would have received $40.34 in interest on their CD. That amount would have to be recorded on their taxes for that year. What is a further downside is that the interest is calculated as interest income, not as a capital gain. One piece of good news is that the investor will only pay taxes on the interest that was earned for that tax year. If they take out a five-year CD, in the fifth year, they will only pay taxes on the interest accrued in that year, not on any interest accrued in the prior years.

The financial institution that issues the CD will provide the owner with a 1099-INT statement that documents how much interest the CD accrued for that tax year.

In general, investors can remove money from a CD prior to maturity, but they will have to pay what is called an early withdrawal penalty. This will vary depending on the lending institution and the length of the CD. The penalty is specified when the CD is purchased and is typically equal to an established amount of interest. Although investors should take care to put money into a CD that is truly disposable, there are a couple of occasions where they may need to make a withdrawal.

1. Financial hardship – None of us can predict the future, and from time to time investors may need money to get through a period of financial hardship such as, perhaps a period of extended unemployment, or an unexpected medical bill.
2. They want to take advantage of a better rate – Sometimes the owner of a CD may want to take advantage of a better rate of return on another CD. In some cases, the higher interest rate may make it worth it to pay the penalty.

This will depend on whether the CD is negotiable or non-negotiable. The majority of CDs are non-negotiable this means they cannot be bought, sold, transferred or exchanged with another party. However, they can usually be cashed out before their maturity date. Negotiable CDs, on the other hand, can be traded on a secondary market, but they cannot be redeemed early. A negotiable CD is a large or jumbo CD meaning it is issued in at a value of $100,000 or more. And, these CDs are typically short-term meaning that they have maturity dates that range from two weeks to twelve months.

At maturity, investors have two options. The first option is to simply cash out the CD, usually into their existing checking or savings account if the CD is purchased through a bank. The second option is to re-invest the CD into another CD. This allows investors to continue to take advantage of compound interest. It’s also a way to hedge against fluctuating interest rates. A common technique used when re-investing CDs is the concept of laddering CDs.

To create a CD ladder, multiple CDs are purchased at varying maturities. For example, an investor could choose to invest a total of $20,000 evenly into CDs at one-year intervals between one and five years. As each certificate expires, the investor will re-invest the CD into a fixed-rate 5-year CD. In this way, every year they will have a CD expiring, but they will have access to at least $4,000 (+ accrued interest) annually. This chart without interest numbers helps illustrate the concept of a CD ladder.

The vast majority of CDs range in length from three months to five years. When considering what length is right for an investor, they should consider their personal financial situation for predictable risk. Although the rate of interest is greater for longer-term CDs, investors who want to minimize the risk of withdrawing funds before maturity may want to take out shorter CDs with shorter maturity periods. Also, if an investor feels that interest rates are likely to rise in the near future, they may choose a shorter term so that they can more easily move their money to a product with a higher interest rate.