Certificates of Deposit

Definition

Certificates of deposit (CDs) are financial products offered by banks and credit unions that provide a fixed interest rate for a specified term in exchange for a deposit of funds. They are considered a low-risk investment option and typically offer higher interest rates than regular savings accounts, making them attractive for savers looking to grow their money over a set period.

5 Must Know Facts For Your Next Test

1. CDs have fixed terms that typically range from a few months to several years, with longer terms usually offering higher interest rates.
2. Early withdrawal of funds from a CD before its maturity date often results in penalties, which can reduce overall earnings.
3. CDs are insured by the Federal Deposit Insurance Corporation (FDIC) up to certain limits, providing security for depositors against bank failures.
4. They are part of the M2 measure of money supply, which includes all M1 components along with savings accounts and other near-money assets.
5. Banks use CDs to attract deposits that can be used for lending purposes, contributing to their role in the financial system.

Review Questions

• How do certificates of deposit compare to traditional savings accounts in terms of interest rates and access to funds?
  • Certificates of deposit generally offer higher interest rates compared to traditional savings accounts due to the fixed term commitment required by depositors. However, unlike savings accounts, which allow easy access to funds, CDs restrict access until the maturity date unless the depositor is willing to incur penalties for early withdrawal. This difference makes CDs a better option for individuals looking to earn more interest without needing immediate access to their money.
• Evaluate the impact of early withdrawal penalties on the attractiveness of certificates of deposit as a savings vehicle.
  • Early withdrawal penalties can significantly reduce the overall returns from certificates of deposit, making them less attractive for individuals who may need access to their funds before the maturity date. These penalties create a trade-off between securing higher interest rates and maintaining liquidity. For savers who can commit their funds for the full term without needing immediate access, CDs remain appealing; however, those who prioritize flexibility may prefer alternative options like savings accounts.
• Assess how certificates of deposit contribute to the overall banking system and influence monetary policy.
  • Certificates of deposit play a crucial role in the banking system by providing banks with stable funding sources that can be used for lending and investment activities. This stability supports economic growth as banks lend out these deposits to businesses and consumers. Additionally, the attractiveness of CDs can influence monetary policy by impacting consumer savings behavior; when interest rates on CDs rise, it may encourage more saving versus spending, which can affect overall economic activity and growth. Thus, monitoring CD rates helps central banks gauge consumer confidence and spending trends.

Related terms

Interest Rate: The percentage charged on a loan or earned on an investment, which determines the cost of borrowing or the return on savings.

Savings Account: A deposit account held at a financial institution that allows individuals to earn interest on their deposits while maintaining easy access to their funds.

Liquidity: The ease with which an asset can be converted into cash without significantly affecting its value.