If you can afford to give up access to your savings for a long period of time, a certificate of deposit (sometimes called a “bank CD”) might be a good investment for you. Certificates of deposit are considered a “time deposit” with a bank. A time deposit differs from the type of deposits you are probably used to.
With a checking or savings account, you are able to deposit money with a bank and then demand that money back at any time. This is called a “demand deposit.” A time deposit means that you must deposit your money with a bank for a set period of time.
When you allow the bank to use your money for an extended period of time, and give up access to it, the bank compensates you with a higher rate of interest than you would otherwise get from a deposit.
Bank CDs typically pay an interest rate that is several percentage points higher than a savings account or money market checking account.
The bank uses your deposit to make loans or for other investment purposes. The interest you earn is a percentage of the interest the bank earns on its investment. However, even if the bank is unsuccessful with its investment activity, it still pays the stated interest rate for the bank CD.
For example, a bank may promise to pay you 4 percent on your CD. The bank will take the money you give it, and perhaps loan it out to other bank customers or invest it somewhere where it thinks it can earn an attractive rate of return.
If the borrower defaults, or the investment performs poorly, you still get the 4 percent that the bank promised. The bank can guarantee this 4 percent because the deposit is insured by a federal agency called the Federal Deposit Insurance Corporation (FDIC). The bank pays insurance premiums to guarantee your deposit. This makes investing in a bank CD very safe and predictable.
Since the bank must pay the promised interest rate on the bank CD, the investments it makes with your deposit have to be very conservative. Because of this, you normally won’t earn a high rate of return from a bank CD.
This is especially troublesome if inflation is high since inflation represents a real loss of the value of your savings. The bank can promise to pay you a specific interest rate, and credit your account with a specific amount of money, but it cannot guarantee what that money will be worth in the future.
Another disadvantage to bank CDs is that you must commit to a long holding period. It’s not uncommon for CDs to be scheduled for 5 or 10 years, even though 3 and 6 month CDs do exist. The shorter the time deposit, the lower the interest rate on the CD is.
If you decide that you want your money back before the CD has fully matured (i.e. before the end of the CD’s term), then you will pay a penalty which usually amounts to 3 months worth of interest earnings. This expensive early-termination fee can erase most of your investment returns on a short-term certificate of deposit.
Bank CDs are also subject to current income taxes. The interest, regardless of whether you receive it or not, is considered investment income. Because you pay current income taxes on the bank CD’s earnings, you cannot take full advantage of compounded earnings from the CD. This, in turn, will result in a lower total investment return than if you had been allowed to defer the payment of taxes on your investment interest.
Post contributed by Elizabeth Goldman on behalf of Wonga.co.za