Certificates of Deposit (CDs)
Certificates of deposit (CDs) are bank time deposits that cannot be withdrawn on demand. 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 of the CD. When a CD matures, you can withdraw the money, transfer it to a savings or checking account, or roll it 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 1st beneficiary, who would just be replacing the deceased owner.
CDs were 1st 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 can't be sold before maturity, so the investor can only receive payment from the issuing bank. If the money is withdrawn before maturity, then the bank pays less interest as an early withdrawal penalty.
The early withdrawal penalty (EWP) is usually specified as forfeited interest for a specific number of months.
Negotiable CDs, introduced in the early 1960s, can be sold before maturity in the secondary money market. However, only short-term CDs — less than 3 months — have an appreciable market.
Retail negotiable CDs, with denominations of $100,000 were introduced by Merrill Lynch in 1982. Nowadays, other security firms also offer CDs, and most stand ready to buy back their CDs before their maturity if the investor wants her money early.
Large-denomination negotiable CDs are CDs with denominations of $1,000,000 or greater, and constitute the largest part of the negotiable CD market. Most of the investors of these CDs are investment companies and money market funds, although some banks, municipalities and corporations also buy CDs.
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, then 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. For 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. Although there are some CDs without penalties, the terms are usually limited to around 1 year.
Some CDs do not allow partial withdrawals of principal, so the only way to get your 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 you earn $10 or more in interest in a year, your 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 that are 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, probably the most important consideration is interest rate yield. Online banks usually offer the highest rates because they do not have to 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.
The best way to find the best CD rates is to simply do a search of the web for "best CD rates" right before buying. Numerous pages of websites that track CD rates will be displayed. Look at a few of them to get the broadest exposure and make sure that the list is up-to-date, right up to the current month.
Always be sure that the CD is covered by federal deposit insurance!
When a CD matures, most financial institutions offer a grace period of 7 to 10 days when you can choose to withdraw the money, transfer it to another account or another financial institution, or roll it over into another CD. Many CD issuers have automatic rollovers. Never choose automatic rollovers: always reevaluate the best use of your money when the CD matures.
Another important consideration is when you will need the money or if there is the possibility of better investment opportunities later on. 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, then 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 the following:
- 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 interest rates are higher the longer the term, but longer terms also reduce liquidity. A way to take advantage of 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 do not have to buy your CDs from the same financial institution. In fact, you will probably 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, then 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 known as 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.
FDIC Coverage for CDs = $250,000 × Number of Account Owners × Number of Beneficiaries
For 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
There are several types of CDs:
- 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.
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 does not have to pay insurance to the FDIC for the deposited money, nor is there any reserve requirement for the money. In the United States, the Federal Reserve imposes a reserve requirement on money deposited in U.S. banks. Domestic banks must, therefore, deposit some of the money in its Federal Reserve account, which does not earn any interest, so the bank is not able to use all the money for its business — hence, it pays a lower rate.
Example: What is the actual cost to a bank with a 5% Federal Reserve requirement of a 1-year $100,000 CD paying 6% interest?
Because the bank must keep 5%, or $5,000, of the money in a Federal Reserve account that pays no interest, the $6,000 interest that the bank is paying is on $95,000, yielding an actual interest rate of 6,000/95,000 ≈ 6.32%. A simpler way to calculate the bank's cost is to multiply the interest rate on the CD by 1 plus the Federal Reserve requirement percentage.
Actual Cost to Bank = CD Interest Rate × (1 + Federal Reserve Requirement Percentage)
In this case, the equation would be:
6% × 1.05 = 6.3%
Adding a typical 8 basis points (0.08%) to the interest rate for FDIC insurance increases the bank's actual cost to 6.4%.
The other factor increasing the yields on Euro CDs is the lack of information regarding the issuer and its government and laws, which creates 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.
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:
|x||Term of |
(Days using relevant
Example 1: If a CD issued in the U.S. (Day-Count Convention: Year = 360 days) pays 5% and has a face value of $100 and a term of 90 days, then the amount received at maturity = $100 × (1 + .05 × 90/360) = $101.26, of which $1.26 is interest.
If the CD sold is sold before maturity, then the market price will depend on the market yield, which is what other interest paying instruments with similar characteristics and credit quality are paying, so the market price will be equal to:
|=||Maturity Proceeds |
1 + Market Yield ×
Days Left to Maturity
(Days using relevant
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%, then the market price would be:
1 + .04 × 60 / 360
1 + .04 × 60 / 360
1 + 0.007
If the CD is sold before maturity, then the investment return for the holding period on the CD =:
|CD Holding |
|=||[||1 + |
Purchase Yield ×
(Purchase Date − Maturity Date)
in Days / Year
Sale Yield ×
(Sale Date − Maturity Date)
in Days / Year
|− 1||]||×||Year |
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:
|CD Holding |
|=||[||1 + .04 × 60 / 360 |
1 + .03 × 31 / 360
|− 1||]||×||360 |
|− 1||]||×||360 |
Calculating Negotiable CD Prices Using Microsoft Excel
Microsoft Office 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)
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 = $100,318.00
Note: The above calculations were made using Microsoft Office Excel 2007. These functions are also available in earlier versions of Excel.
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, then the CD must be sold in the secondary market of limited liquidity. If interest rates are rising, then 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, then 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, and then adjusted afterward: step-up CDs are adjusted upward, paying higher yields later in their term, while the step-down CDs are adjusted lower.