What Is a Term Deposit?
Anyone looking for a safe place to stash their money and generate returns may consider a term deposit. But what is a term deposit, and how does it work? Here’s a closer look.
What Is a Term Deposit?
A term deposit is a savings option for those seeking to keep their money secure over a fixed period.
The term is the length of time the money must be kept in the account, which may go by the name “certificate of deposit” or “time deposit.” In return for giving up access to the money during the term, the customer is paid interest by the bank. At the end of the term, the deposit matures and the bank notifies the customer that the money is available again. Funds can be rolled into a new term deposit, withdrawn or invested elsewhere.
Banks set the term length for these accounts, which is usually three months to five years. It may also set a minimum deposit amount, although some accounts don’t require a minimum.
Term Deposit vs. Fixed Deposit
In some countries, similar accounts are offered as “fixed deposits,” which differ in offering higher interest over a longer term than a typical term deposit.
Term Deposit vs. GIC
In Canada, a guaranteed investment certificate works much like a term deposit. The money is kept in the account for a preset term and returned with interest. The Canadian government guarantees GICs up to $100,000.
Good To Know
As the maturity date approaches, the bank or credit union holding a term deposit will notify the customer. The saver will be notified of any running grace period that sets a deadline for rolling over the funds into a new CD. Some CD accounts can be set to automatically renew after the grace period expires.
The value of a term deposit lies in its safety. Term deposits are insured by the Federal Deposit Insurance Corporation. This federal agency guarantees the return of the funds in a term deposit if the bank fails or otherwise loses the money.
The FDIC insures term deposits up to $250,000 per account ownership category, per bank.
Ownership account categories include:
The FDIC does not count separate branches of a single bank as different deposit locations for insurance purposes.
For credit unions, the insurance is provided by the National Credit Union Administration. This entity also insures $250,000 per depositor, per institution and per account ownership type. Deposit insurance provides an extra measure of safety, making a term deposit a good location for money that needs to be saved and not put at risk.
The bank returns the funds to the customer on the maturity date with interest. In return for the safety term deposits provided, a relatively low interest rate is paid on the money.
Banks and credit unions rely on these deposits to provide funds needed for lending. The difference between the interest paid to savers and charged to borrowers is known as the net interest margin. This is an important measure of profitability for the bank.
In times of rising interest rates, banks will pay more on term deposits to attract customers. They will also raise the rates they demand from their borrowers. The difference between the two generally narrows when rates go up, so the net interest margin decreases. When the bank borrows for its own operations, its interest costs will also rise.
The highest term deposit rates are paid on so-called “Jumbo” CDs, which in most cases have minimums set at $100,000 or more.
Demand and Term Deposits
There’s an important difference between demand and term deposits worth noting. A demand deposit holds funds that can be returned to the customer at any time on demand. A checking account is a demand deposit, as is a conventional savings account. When the customer demands the money, the bank must provide it without penalty. In return for this availability, the bank pays low or no interest on the money.
By contrast, a term deposit holds funds that are locked up for a time. If the holder of a term deposit requests a return of the money before maturity, the bank will charge a penalty — so no money will be lost on a term deposit.
Tiered and Variable Rates
Banks and credit unions have various ways to structure term deposits to pay a more competitive rate of interest.
Higher rates are paid on larger balances with a tiered deposit. For example, a deposit of $8,000 may earn a higher rate of interest than a $5,000 deposit. The tiered account is a marketing strategy banks use to attract larger deposits from their customers.
Variable rate CDs don’t pay a fixed rate. The rate can be adjusted regularly to keep up with rising interest rates. This takes some of the burden off of the individual saver on the hunt for the best possible return for money kept safe.
Annual Percentage Yield
In describing their deposit options, banks and credit unions will disclose interest rates paid as well as “annual percentage yield.” The APY is the total return on the money after a year. Since interest is credited at regular intervals, the balance will increase and the higher amount of interest paid on the larger balance is then included in the APY.
With compounding interest in a term deposit account, the APY will be higher than the advertised interest rate. The APY provides a convenient way to compare rates and funds in different term deposit accounts, as APY reflects the actual amount to be returned to the saver.
Term Deposits and Inflation
It’s important to remember that money generally loses value over time. This occurs as more money is printed and goes into circulation — the more dollars flowing through the economy, the lower the value of individual dollars.
Inflation spiked in 2022 as the economy recovered, wages rose, higher demand met limited supply and COVID-19 stimulus funds from the federal government were spent, earned and saved. Inflation forces prices to rise, and as time goes on, it takes more money to buy the same amount of goods.
Inflation is an important consideration when saving or investing. A term deposit paying interest lower than the inflation rate means a reduction in the purchasing power of the money. Although it’s safe, the money has lost value and won’t buy as much at the end of the term.
Recent CD Interest Rates
A recent Forbes article highlighted several certificate of deposit promotions by various financial institutions. In 2022, the interest rates paid by banks and credit unions are rising along with prices and wages. For example, Capital One offered 1.20% interest on a one-year CD and 1.60% on a two-year. According to the same survey, other banks were paying 0.50% to 1.80%.
At the same time, however, the inflation rate is also increasing. By April 2022, inflation was hovering around 8.5% annually. That means a loss of purchasing power of at least 6% on a certificate of deposit. If the term exceeds a year, the loss will likely be even greater.
Nevertheless, savers want safety for their money and will accept this loss to achieve it. If they’re willing to accept more risk for a higher return, they can turn to U.S. Treasury bonds, corporate bonds or the stock market — investments that are not insured. They also have laddering, a strategy to deal with the loss of purchasing power over long periods.
Laddering means setting up term deposits with different maturities. For example, a savings fund can be divided into five CD accounts with maturities spread over five years. The interest rate paid on the longer-term accounts will be higher.
Every year one of the accounts will mature, and at the option of the saver, the money can be rolled into a new CD. If inflation persists and interest rates rise, this new CD will pay a higher interest rate.
With laddering, the savings fund earns more over time than it would in a single term deposit account.
Banks and credit unions will allow term deposit customers to close their accounts before maturity, but a penalty is usually charged. In most cases, that means a loss of the interest due on the account.
Federal law sets a minimum early withdrawal penalty that the bank must charge. It is possible to request a waiver of this penalty, and while the COVID-19 pandemic raged in 2020 and 2021, the government encouraged banks to allow these waivers in hardship cases. But the same law that sets a minimum penalty also does not require banks and credit unions to waive fees under any circumstances.
Nevertheless, if rates are rising, a saver might come out ahead by closing a term deposit account before maturity and moving the money into a new one paying a higher interest rate.
On maturity, the interest paid on a term deposit becomes taxable interest income and must be reported to the IRS. This is true whether or not the money is rolled into a new term deposit account. If the CD term is longer than the year, the IRS wants the portion of the interest paid in each year reported. This often means paying taxes on money still locked up at the bank.
For traditional IRA accounts or tax-advantaged 401(k)s, the interest earned remains tax-free until the money is withdrawn from the account. For Roth retirement accounts, withdrawals are tax-free.
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- Forbes. "Forbes."
- Fidelity. "Model CD Ladders."
- Code of Federal Regulations. 2022. "PART 1030 - TRUTH IN SAVINGS (REGULATION DD)."
- NBC News. 2022. "What is causing inflation? Economists point fingers at different culprits."
- FEDERAL DEPOSIT INSURANCE CORPORATION. 2020. "Your Insured Deposits."
- National Credit Union Administration. "HOW YOUR ACCOUNTS ARE FEDERALLY INSURED."
- Corporate Finance Institute. "Net Interest Margin."
- HelpWithMyBank.gov. 2021. "What are the penalties for withdrawing money early from a certificate of deposit (CD)?"