Certificate of Deposit: Definition, Advantages & Disadvantages

Lesson Transcript

Douglas has two master's degrees (MPA & MBA) and a PhD in Higher Education Administration.

Certificates of deposit are useful documents for both banks and depositors. Examine the definition of a certificate of deposit and evaluate their advantages and disadvantages for both banks and investors. Updated: 11/14/2021

What is a Certificate of Deposit?

When you deposit money into your bank account, those funds become part of that bank's total deposits. The bank uses those funds to lend to other customers, collecting interest on those loans and thereby making a profit. But one issue banks always need to think about is that they can't predict, to an exact science, when you will come back and want your money. They can't loan out all of their money, because their customers will want to withdraw money at unknown rates and times.

One way banks have addressed this uncertainty is to offer a financial investment called a certificate of deposit or CD. A CD is an agreement between a depositor and the bank that the depositor won't withdraw the money for a certain amount of time in return for earning interest on those funds.

The amount of time the depositor must leave the money alone and not withdraw it varies, based on the term of the CD. Some banks offer CDs for as short as 3 months, while 6-month and 12-month terms are more common. The longer the term, and the larger the amount of the deposit, the higher the interest rate paid on the deposit. In mid-2015, a 3-month CD for $5,000 would receive about a .6% annual percentage rate (APR) return.

There's an important note to make here. The 3-month, $5,000 CD received .6% annualized. That's the rate over the course of a year, and the term of this CD is only 3 months, meaning it will only earn about ¼ of the interest. So, while a .6% return on $5,000 would be about $30 per year, because the term is only ¼ of a year (3 months) the realized return would be closer to $7 or $8 (¼ of $30). Not a big return, and we'll talk about why below.

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Advantages of Certificates of Deposit

There are a number of advantages of CDs. First of all, as we discussed earlier, the term and amount are flexible. If you don't want to lose control of your money for too long, you could just purchase a 3-month CD. If, at the end of the 3 months you still want to invest, you can buy another 3-month CD. So, there's very little risk of losing control of your money for a long time.

CDs are also very, very safe investments. In fact, they have basically no risk. CDs are still covered by federal deposit insurance and banks still consider them savings deposit. If a CD went bad, it would be because the economy was in extremely bad shape, and the CD would probably be the least of your worries! CDs survived the Great Depression, the Savings & Loan Crisis in the 1980s and the Great Recession of 2008.

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