A Certificate of Deposit (CD) is a negotiable certificate issued by a bank in return for a term deposit of up to five years. They originated in the USA in the 1960s. From 1968, a sterling CD was issued by UK banks. They were intended to enable the merchant banks to attract funds away from the clearing banks with the offer of competitive interest rates. However, in 1971 the clearing banks also began to issue CDs as their negotiability and higher average yield had made them increasingly popular with the larger investors. A secondary market in CDs has developed, made up of the discount houses and the banks in the interbank market. They are issued in various amounts between £10,000 and £50,000, although they may be subdivided into units of the lower figure to facilitate negotiation of part holdings.
Historical Context
Origin and Evolution
- 1960s, USA: Introduction of Certificates of Deposit (CDs) to attract savings and offer higher yields.
- 1968, UK: Sterling CDs started being issued by UK banks to provide competitive interest rates.
- 1971, Worldwide: Clearing banks joined the issuance, enhancing popularity among larger investors.
Key Events
- Introduction of negotiable CDs: Provided liquidity and flexibility for larger investors.
- Development of a secondary market: Enabled easier trading and greater appeal.
Types of Certificates of Deposit
Traditional CDs
- Fixed interest rates.
- Fixed term length.
Jumbo CDs
- Large denominations (typically $100,000 and above).
- Higher interest rates due to larger investments.
IRA CDs
- Integrated into Individual Retirement Accounts (IRAs).
- Tax advantages for retirement savings.
No-Penalty CDs
- Allow early withdrawals without penalties.
- Lower interest rates compared to traditional CDs.
Detailed Explanations and Models
Interest Calculation Formula
CD interest can be calculated using the simple interest formula:
- \( P \) is the principal amount.
- \( r \) is the annual interest rate.
- \( t \) is the time in years.
Example
For a $10,000 CD with a 3% annual interest rate for 5 years:
Charts and Diagrams
Mermaid Diagram
graph LR
A[Bank] -->|Deposits| B[Certificate of Deposit]
B -->|Fixed Term| C[Investor]
C -->|Negotiable in Secondary Market| D[Discount Houses]
D -->|Trading| E[Interbank Market]
Importance and Applicability
- Security: CDs are typically insured by the FDIC, providing a high level of security.
- Predictability: Fixed interest rates and terms offer stable returns.
- Diversification: CDs can be part of a diversified investment portfolio.
Examples
Example 1: Small Investor
- Investment: $5,000 in a 2-year CD with a 2% interest rate.
- Returns: Predictable and secure returns of $200 over the term.
Example 2: Large Corporation
- Investment: $500,000 in a jumbo CD for 1 year with a 1.5% interest rate.
- Returns: Secure income of $7,500 while keeping funds safe.
Considerations
Early Withdrawal Penalties
- CDs generally impose penalties for early withdrawal, which can reduce returns.
Interest Rate Risk
- Interest rates are fixed; therefore, they may be lower than market rates over time.
Related Terms and Definitions
Savings Account
A bank account that earns interest on deposited funds with high liquidity.
Money Market Account
A type of savings account offering higher interest rates and limited transaction capability.
Bond
A fixed-income investment representing a loan made by an investor to a borrower.
Treasury Bill (T-Bill)
A short-term government debt obligation with a maturity of one year or less.
Comparisons
CDs vs. Savings Accounts
- Interest Rates: CDs usually offer higher interest rates.
- Liquidity: Savings accounts offer higher liquidity without penalties for withdrawal.
CDs vs. Bonds
- Term: CDs have shorter terms compared to bonds.
- Risk: CDs are usually considered safer due to FDIC insurance.
Interesting Facts
- CDs played a significant role in the development of modern savings products.
- Some banks offer promotional rates to attract deposits through CDs.
Inspirational Stories
Mary’s College Fund
Mary used a laddering strategy with CDs to ensure part of her investment matured every year, funding her child’s college expenses predictably and securely.
Famous Quotes
“Don’t put all your eggs in one basket.” – Proverb on Diversification
Proverbs and Clichés
- “A penny saved is a penny earned.”
- “Safe as houses.”
Expressions and Jargon
Jargon
- Laddering: A strategy to spread investment across multiple CDs with different maturities.
- Negotiability: The ability to transfer or sell a CD before its maturity date.
FAQs
What happens if I need to withdraw my money before the CD matures?
- You may face early withdrawal penalties, which can vary by bank and CD terms.
Are CDs a good investment for short-term goals?
- Yes, due to their security and predictable returns, CDs can be suitable for short-term goals.
Is interest earned on a CD taxable?
- Yes, the interest earned is typically subject to federal and state taxes.
References
- “The History and Evolution of CDs.” Financial Times.
- “CDs vs. Savings Accounts.” Investopedia.
- Federal Deposit Insurance Corporation (FDIC) official website.
Final Summary
A Certificate of Deposit (CD) is a secure and predictable investment vehicle offered by banks, providing fixed interest rates over specified terms. Originating in the 1960s, CDs have become popular due to their negotiability and high yield, with a robust secondary market enhancing their appeal. They offer various types to meet different financial goals and are an essential part of diversified investment strategies. Despite the potential for early withdrawal penalties and interest rate risk, CDs remain a reliable choice for investors seeking security and steady returns.
