Certificates of Deposit and Time Deposits
A certificate of deposit is a fixed-term deposit at a bank that pays a set interest rate in exchange for the depositor agreeing not to withdraw the money early, giving banks a more predictable funding source than ordinary savings accounts.
A regular savings account lets you withdraw money whenever you want, which is convenient for the depositor but inconvenient for the bank, which cannot lend that money out with confidence. A certificate of deposit (CD) trades that flexibility away: the depositor commits funds for a fixed term — a month, six months, a year — and in exchange receives a higher interest rate than an on-demand account would pay.
A CD is a fixed-term deposit that pays a higher rate than an instant-access account, because the bank knows exactly when it can expect the money back and can plan its own lending around that certainty.
CDs come in retail sizes for individual savers and much larger "negotiable" wholesale CDs, often $1 million or more, that banks issue to corporations and money-market funds as a core piece of short-term funding. Negotiable CDs can also be resold before maturity in a secondary market, which retail CDs typically cannot.
Worked example. A corporate treasurer has $5 million in idle cash for exactly 90 days. A bank offers a 90-day CD at 4.80%, versus 4.50% on an instant-access deposit. Locking the $5 million into the CD for 90 days earns roughly , i.e. $60,000 in interest, about $3,750 more than the instant-access alternative, in return for giving up access to the cash before day 90.
Early withdrawal from a CD, where permitted at all, usually carries a penalty equal to some months of forfeited interest, which is the bank's compensation for having its funding certainty broken.
Further reading
- Stigum's Money Market (7th ed., ch. on bank deposits)