What is a Certificate of Deposit (CD)?

//What is a Certificate of Deposit (CD)?
What is a Certificate of Deposit (CD)? 2017-10-01T07:05:56+00:00

Definition: A certificate of deposit (CD) is a short-term security with a fixed interest rate and maturity date issued by a bank that seeks to raise funds from the secondary money market.

What Does Certificate of Deposit Mean?

What is the definition of certificate of deposit? Certificates of deposit are a special form of term deposits, which are issued for a specific reference period, usually up to 12 months, for a certain amount and a certain interest rate, fixed or variable, traded in the secondary money market. Regardless of the duration of a CD, the issuing bank is bound to pay off the coupons to the holder.

Short-term CDs have no coupons, and the holder receives the principal and accrued interest at maturity. However, in the case of a long-term certificate of deposit, the coupons are paid at regular intervals like, for example, every six months. The trading price of a CD in the secondary market is determined by its yield to maturity.

Let’s look at an example.

Example

Mary purchases a $10,000 CD at a fixed interest rate of 4% and maturity in 5 years. So, in year 1, she has $10,400, in year 2, she has $10,816, in year 3, $11,249, in year 4, $11,699, and in year 5, $12,167.

If Mary decides to withdraw her money before maturity, she will incur an early withdrawal penalty. Therefore, at the end of the year 3, when the value of the CD will be $10,816, Mary will be charged with 3/12 of the annual interest earned. Hence, instead of getting $11,249 in year 3, she will get $11,249 – ($433 x 3 / 12) = $11,140.48.

Certificate of Deposit Example

Although early withdrawal from a CD is allowed, there is a penalty incurred. The amount of the penalty is subject to the total duration of the CD and the issuer. However, in general, an early withdrawal penalty is equal to a percentage of the amount of interest.

Also, the long-term CDs assume that the holder seeks a higher return. However, there is also a higher level of risk associated with long-term CDs because the holder will hold the CD for a longer period of time than a short-term CD; hence, the level of uncertainty is higher.

Summary Definition

Define Certificate Deposit: CD means an investment security issued by a bank with a fixed interest rate and maturity date.