Certificates of Deposit (CDs)

Certificates of deposit (CDs) are bank time deposits that cannot be withdrawn on demand without penalty. CD interest rates, usually expressed as an annual percentage yield (APY), are slightly higher than for savings accounts, but in exchange for the higher interest rates, the money must be left in the account for a specified time. Both interest and principal are paid at the maturity. When a CD matures, the money can be withdrawn, transferred to a savings or checking account, or rolled into another CD.

CDs can have any term, but Federal Reserve regulations require that it be at least 7 days. Up to $250,000 of a certificate of deposit is insured by the Federal Deposit Insurance Corporation (FDIC). Specifying more than 1 beneficiary can increase FDIC coverage, up to $250,000 of additional coverage per beneficiary other than the 1^st beneficiary, who would just be replacing the deceased owner.

CDs were 1^st introduced in the sterling (UK) market in 1958 and in the US market in 1964. The largest investors of CDs are banks, money market funds, corporations, and local government agencies.

CDs can be negotiable or nonnegotiable. Nonnegotiable CDs (aka traditional CDs) can't be sold before maturity, because they are nothing more than savings accounts at the issuing bank subject to certain provisions, so the investor can only receive payment from the issuing bank. If the money is withdrawn before maturity, the bank pays less interest as an early withdrawal penalty (EWP), usually specified as forfeited interest for a specific number of months.

Brokered CDs

Traditional banks are not in the business of providing services to trade securities, which is why their CDs cannot be sold in the general market. Instead, banks sell CDs or lend money to brokers, who then subdivide the money into individual certificates of deposit. Because brokers provide trading services, they can allow their customers to trade their CDs, which is why they are called brokered CDs. After all, brokered CDs, like stocks and bonds, are merely electronic records in a database at the brokerage.

Brokered CDs are sold directly to customers by broker/dealers and usually have different terms than traditional CDs. The terms may be several years and usually have a higher yield, but if investors want their money sooner, the CD must be sold in the secondary market of limited liquidity. If interest rates are rising, the principal will decline. Brokers or dealers may also charge a commission to sell these brokered CDs. The issuing broker/dealer may also make the brokered CD callable, so that if interest rates fall, the CD can be called, forcing buyers to reinvest at lower interest rates. Most brokered CDs qualify for FDIC insurance of up to $250,000.

The minimum purchase is $1,000; larger purchases must be in increments of $1,000.

Brokered CDs may also have a step-up or step-down feature, where the interest rate is fixed for a certain period, such as 1 year, then adjusted afterward: step-up CDs are adjusted upward, paying higher yields later in their term, while step-down CDs are adjusted lower.

Advantages of Brokered CDs

Brokered CDs, like stocks and bonds, can be sold before maturity. They can be transferred to another brokerage. And because most brokers sell CDs from many different institutions, investors have more choices of interest rates and terms. Terms can range from 1 month to 30 years. They could also have additional features, such as call protection.

Furthermore, CDs issued by different FDIC-insured banks are separately covered by FDIC insurance from each bank, up to $250,000. Most major brokers only sell CDs from FDIC-insured banks, but it would be prudent to verify that. However, holding CDs in a brokerage account may not be as safe as this suggests since SIPC insurance on brokerage accounts have a $500,000 limit. Though there is a $250,000 limit to cash under SIPC coverage, brokered CDs are considered securities rather than cash, so they have the full $500,000 coverage. However, if the broker fails, coverage is limited to $500,000. FDIC insurance would only cover CDs issued by a failing bank; it will not cover CDs held in a brokerage account if the broker goes bankrupt. (There may be higher insurance limits for brokerage accounts if the broker has bought private insurance to raise the limit.)

Disadvantages of Brokered CDs

Though brokered CDs can be sold, there is usually a small fee and possibly a markup by the broker. Furthermore, liquidity is limited since CDs are not fungible, and the market is usually restricted to the broker’s alternative trading system.

There is also interest rate risk. The market price of a brokered CD will depend on the issuer's creditworthiness and prevailing interest rates. Furthermore, what matters in the secondary market is not the coupon rate but the yield to maturity, or, if the CD is callable, the yield to worst.

Federally Guaranteed Deposit Insurance

The federal government has 2 types of insurance programs that will reimburse depositors for their loss if their institution fails. FDIC insurance covers bank-issued CDs, up to $250,000 per CD owner at each FDIC-insured bank. So, if you own 3 CDs at different FDIC-insured banks, you will have $250,000 coverage at each institution for a total coverage of $750,000. Because CDs are considered a different category of ownership, you can have a savings account and checking account, each holding $250,000, and a certificate of deposit at the same bank also holding $250,000 and still be covered. Use FDIC: Electronic Deposit Insurance Estimator (EDIE) to ensure how much coverage is available.

Credit unions also sell federally insured CDs, often calling their CDs share certificates. Credit unions are not insured by the FDIC, but are covered by the National Credit Union Administration (NCUA). The NCUA is like the FDIC: both are federally-run agencies insuring accounts of up to $250,000 per person, per ownership category, per institution. As with banks, different ownership categories include checking accounts, savings accounts, and CDs, so you could be covered up to $250,000 for each type of account at the same institution. Use Credit Union Locator | MyCreditUnion.gov to ensure that the credit union you are considering is covered.

CD Penalties and Fees

Most penalties are expressed as the amount of interest earned over a set time. The number of months of interest forfeited increases proportionally to the term of the CD. Example:an early withdrawal from a 1-year CD could trigger a penalty equal to 3 months’ interest, while a 5-year CD withdrawal penalty could equal a whole year’s worth of interest. Though some CDs have no penalties, their terms are usually limited to 1 year.

Some CDs do not allow partial withdrawals of principal, so the only way to get money back before the end of the term is to withdraw all the money, close the account and pay the charge.

Taxation of CD Interest

The taxation of CDs follows the taxation of original issue discount bonds. CD interest is subject to federal taxes, and usually state taxes, and maybe even local taxes. If the annual earned interest from a bank is $10 or more, the bank or institution will send you and the IRS Form 1099-INT. Whether you get a 1099 from your institution or not, however, you’re still required to report any interest earned on your taxes. If you earn $1,500 or more, you must also itemize the sources of that interest income on Form 1040, Schedule B.

Even if CD interest is only paid at the end of the term, the CD holder must pay taxes on it every year, as the interest is earned. Early withdrawal penalties can be deducted as an above-the-line deduction. Early withdrawal penalties will be listed in Box 2, Early Withdrawal Penalty, of Form 1099-INT from the issuing institution.

CD Checklist: What to Consider before Buying a CD

CDs offer safety of principal, which is the primary feature of CDs considered by investors. But CDs should always be compared with other investments also considered safe, such as federally insured high-yield savings accounts, Treasuries, brokered CDs, and money market funds. Furthermore, Treasuries and brokered CDs offer the potential for capital gains when interest rates are already high since these securities will increase in price in the secondary market if interest rates drop.

When buying a CD, a major consideration is interest rate yield. Online banks usually offer the highest rates because they do not bear the high cost of maintaining branches. Credit unions often offer higher CD rates than banks. However, credit unions require membership, based on specific criteria, such as living in specific communities or being a member of some organization; some require only a donation.

Another important consideration is when you will need the money or if there may be better investment opportunities later. Since CD terms usually range from 1 month to 5+ years, CDs give you the flexibility to pick the term that will match upcoming financial needs, such as paying for college or saving for a down payment on a home. If interest rates are rising, it may be better to pick short-term CDs so that the money can be reinvested in CDs with higher interest rates or other investments paying more interest.

Financial institutions may also offer 2 disbursement options for interest: to receive the interest periodically or to leave the interest in the CD account to allow compounding. Note that you must pay taxes on the interest earned annually, whether you receive the interest or not.

Other considerations include:

• minimum deposit
  • ranges from $0 to $100,000
  • sometimes the rate earned depends on the deposit amount
• early withdrawal penalties (EWPs)
  • penalties for early withdrawal consists of forfeiting some interest for a specific number of months
  • penalties are often proportional to the term of the CD
  • some CDs have no penalties, but their terms are often limited to 1 year or less
• if interest rates are rising, opting for a CD with no penalty or a small penalty may allow you to move your funds to a new CD paying a higher interest rate
• how many beneficiaries can be specified, if you want to specify more than 1
• software that allows easy management of the CD, such as being able to add, remove, or change beneficiaries

CD Ladders

CD interest rates are higher the longer the term, but longer terms also reduce liquidity. A way to profit from higher interest rates while providing greater liquidity is by constructing a CD ladder. A CD ladder is created by opening several CDs with different maturity terms. As a CD matures, you renew the CD into the longest-term CD in the ladder. This gives you access to a portion of the total CD amount at regular times.

Remember, always search for the best CD rates right before you buy any CD, including CDs that are part of your CD ladder. You need not buy your CDs from the same financial institution. In fact, you may buy your CDs from different financial institutions simply because no one institution offers the best rates all the time. And continue to look at other investments that are also safe but may pay a higher interest rate, such as Treasuries and brokered CDs. Moreover, Treasuries and brokered CDs have the potential for capital gains if interest rates drop. If interest rates rise, you will be no worse off than holding a traditional CD.

Designating a Beneficiary for Your CD

You can designate 1 or more beneficiaries for your CD's. Some banks may only allow the designation of 1 beneficiary. You may also need to provide their Social Security number. An account with designated beneficiaries is called a payable-on-death, or POD, account. Classified as an informal revocable trust account by the FDIC, other commonly accepted terms that identify the account as informal revocable trust accounts include “in trust for” and “as trustee for”. Each beneficiary receives equal shares upon the account holder's death.

Each beneficiary is eligible for up to $250,000 in FDIC coverage per account owner, so by setting up beneficiaries on your account, you can increase your FDIC coverage.

Example:joint account owners who each qualify for $250,000 in FDIC coverage would increase their coverage to $750,000 each if each owner designates 3 beneficiaries.

You can calculate how adding beneficiaries to your deposit accounts and having accounts in different ownership categories will affect your FDIC coverage by visiting the FDIC's Electronic Deposit Insurance Estimator at FDIC.gov/edie.

Types of CDs

Other types of CDs include:

• no-penalty CDs allow a penalty-free early withdrawal, after 6 days of opening the account, but this flexibility is offered at a lower APY
• bump-up CDs allow the CD holder to bump up the CD interest rate to a higher APY when interest rates rise, but the CD holder must usually request it, with the number of requests limited, depending on the term of the CD. Longer terms usually allow more requests. However, the initial CD APY is often lower than other CDs.
• step-up CDs are like bump-up CDs, but the increase in APY is scheduled at predetermined intervals. Note that many CD issuers use the term step-up CDs as synonymous with bump-up CDs, so be sure to understand the details.
• add-on CDs allow the CD holder to make additional deposits before maturity
  • the number of deposits is usually limited to 1 or 2 during the term
  • the amount that can be added may be limited
• variable-rate CDs have an interest rate that can vary based on an index such as the prime rate, but the change in interest rate may be limited to a specific time, such as the start of a new month
• indexed CDs (a.k.a. structured CDs) earn a return that is linked to indexes of other investments, such as stocks, bonds, currencies, or commodities, but the return is usually only a fraction of the return of the linked index.
• CD specials are promotional CDs that banks and credit unions offer to attract more deposits
  • often have nonstandard terms, such as 13 months
  • higher minimum deposit requirements
  • often, must be funded with new deposits at the bank
  • often are automatically renewed into standard CDs with similar maturities and standard rates
• IRA CDs are simply CDs held in IRA retirement accounts

It is important to understand the blended yield of a step-up CD, which is the yield equivalent to a regular CD with a fixed rate. It is best to avoid bump-up CDs and step-up CDs since their small flexibility is offered in exchange for a lower initial APY. The blended yield will usually be lower than the best CDs with fixed yields.

Issuers of CDs

Issuers of CDs are grouped according to the type of bank. The main issuers are domestic banks. Eurodollar CDs (Euro CDs) are denominated on the U.S. dollar but are issued primarily in London by foreign branches of U.S. banks, and by Canadian, Japanese, and European banks. Yankee CDs are also denominated in U.S. dollars and are issued by the United States branches of foreign banks in the United States. Thrift CDs are issued by U.S. depositary banks, such as thrifts, and savings-and-loans banks, which use the deposited money for loans.

CDs can also be grouped as prime CDs or nonprime CDs, depending on the credit rating of the issuer. Prime CDs are issued by highly rated domestic banks; nonprime CDs are issued by smaller, less well-known banks.

CD Yields

Unlike other short-term money market instruments, CDs are not sold at a discount, but pay interest on the money deposited. For CD maturities of less than 1 year, interest is paid at maturity. For term CDs — those with a term of 1 year or longer — interest is paid semiannually. A banker's year of 360 days is used to compute interest for money market instruments issued in the US.

Market yields on CDs are determined by the usual factors that affect rates for fixed-income securities: the credit rating of the issuer, the term of the CD, and market interest rates. Like bonds, the price of negotiable CDs varies inversely with market interest rates: when market interest rates decline, CD prices increase, and vice versa. A major determinant of CD yields is the bank's demand for money for loans and the cost of alternative sources of funding, such as commercial paper. The greater the demand or the higher the cost of alternative funding sources, the greater the yields paid on CDs.

Yankee CDs yield more than issues by domestic banks, because investors are not as familiar with foreign banks, and, hence, a lack of information increases the perception of credit risk.

The issuers of Euro CDs have several advantages that allow them to pay a higher interest rate. Because the issuer is not subject to United States laws and regulations, the issuer of a Euro CD need not pay insurance to the FDIC for the deposited money, nor is there any reserve requirement for the money.

The other factor increasing yields on Euro CDs is the lack of information regarding the issuer and its government and laws, creating some uncertainty as to repayment, and there may be sovereign risk, the risk that if the issuer does not repay the CD, it will be difficult to collect because the issuer is located in another country with different laws and regulations, or the government may not enforce its laws. However, this sovereign risk premium is small for most modern nations since investors shun risky countries.

CD yields are slightly higher than for Treasury securities of the same maturity, because of a higher credit risk and an illiquid secondary market. The yield differential may be higher if there is a crisis in the banking system, such as the subprime mortgage crisis during the Great Recession, which caused Treasury security yields to decline while yields on other securities went up.

Negotiable CD Yields

Negotiable CDs have terms of less than 1 year, and since they have a secondary market, their yields will vary with the market interest rate. CDs in the US, like other money market instruments in the US, use the actual/360 day-count convention, so a 1% CD would earn 365/360 × 1% of interest in 365 days. In the United Kingdom, the actual/365 day-count convention is used. Market prices are quoted per $100 of par value. The coupon rate = the stated rate of interest on the CD and is issued at par value. Therefore, the amount received when the CD matures equals:

The market price of a CD sold before maturity depends on the market yield, which is what other interest-paying instruments with similar characteristics, including the same remaining terms, and credit quality are paying, so the market price will equal:

So if the above CD is offered for sale after 30 days, with 60 days remaining to the CD term, and the market yield is now 4%, the market price would be:

If the CD is sold before maturity, the investment return for the holding period on the CD:

The buyer of the CD in Example 2 sells after holding it for 29 days, with 31 days remaining for the term, when the market yield dropped to 3%. The holding period return is:

Calculating Negotiable CD Prices Using Microsoft Excel PRICEMAT Function

Microsoft Excel has the PRICEMAT function to calculate prices of negotiable CDs.

Price of Security that pays interest only at maturity

• = PRICEMAT(settlement,
  • maturity,
  • issue,
  • rate,
  • yield,
  • basis)

• Settlement = Date of settlement.
• Maturity = Date when bond matures.
  • All dates must be entered as Date functions [format DATE(year,month,day)] or as cell references. Entering dates as text may cause problems, as stated in Microsoft's Excel reference.
• Rate = Nominal annual coupon interest rate in decimal form.
• Yield = Annual yield to maturity in decimal form.
• Issue = Issue date of the security.
• Basis = Day count basis.
  • 0 = 30/360 (U.S. basis). This is the default if the basis is omitted.
  • 1 = actual/actual.
  • 2 = actual/360 (this is used for CDs issued in the US)
  • 3 = actual/365 (this is used for CDs issued in the UK)
  • 4 = European 30/360

What is the price of a negotiable, 90-day CD originally issued for $100,000 on 3/1/2008 paying a rate of 8% with a current yield of 6% and a settlement date of 4/1/2008? Here we use the Microsoft Excel Date function, which takes the format DATE(year,month,day) to do some calendar arithmetic. Because the CD is issued in the US, the actual/360 day-count convention is used, which, in Excel, is selected by setting the last parameter to 2.

Market Price of CD

• = PRICEMAT(
  • DATE(2008,4,1),
  • DATE(2008,3,1)+90,
  • DATE(2008,3,1),
  • 0.08,
  • 0.06,
  • 2)
• = 100.318 per $100 of face value
• = $100,318

Note: The above calculations were made using Microsoft Excel.