Certificates of deposit, commonly known as CDs, have a long history in the financial world, dating back to the early 19th century in the United States and even further back in other regions. This article explores the origins, functions, and key aspects of CDs to provide a comprehensive understanding of this popular investment option.
Banks in the U.S. have been offering certificates of deposit since the 1800s, with federal insurance coverage for bank and credit union CDs introduced in the 20th century. Negotiable CDs, designed for larger investments, emerged in the early 1960s.
What Is a CD?
A certificate of deposit represents a contractual agreement between a depositor and a financial institution, like a bank or credit union. The depositor entrusts a sum of money to the institution, which promises to repay the principal with interest on a specified future date. Essentially, a CD functions as both a receipt and a promissory note.
Unlike traditional savings accounts, CDs have limited liquidity, meaning funds are inaccessible before the agreed term without incurring a significant early withdrawal penalty. In return for this commitment, depositors earn higher interest rates compared to savings accounts, with rates increasing based on the duration of the CD, ranging from months to several years.
When the First CDs Were Introduced
Certificates of deposit have a long history, with U.S. banks issuing them from the early 1800s, inspired by European practices dating back even earlier. Originally, investors received elaborately designed certificates to instill confidence. While digital alternatives exist today, paper certificates are still available upon request, detailing the deposit amount, interest rate, and term.
The safety of CDs received formal recognition with federal insurance coverage starting with the establishment of the FDIC in 1933 for bank-issued CDs and extending to credit unions with the NCUA in 1970.
When Negotiable CDs Became Available
Introduced in 1961, negotiable certificates of deposit, or NCDs, cater to institutional investors with minimum denominations of $100,000. These CDs offer some liquidity through secondary market trading while maintaining the principle of no early redemption until maturity.
Unlike standard CDs, NCDs enable investors to trade them before maturity, enhancing their marketability. However, they still adhere to the regulatory framework of traditional CDs, including federal insurance limits.
How Insurance Works for CDs
Federal insurance coverage from the FDIC and NCUA offers peace of mind to depositors, but coverage limits of $250,000 per depositor, per institution, per ownership category apply. Those seeking to exceed this amount can diversify across institutions or account types to ensure full protection.
Brokered CDs, sold by brokerage firms, carry additional risks as they are not directly insured by federal agencies, highlighting the importance of due diligence before investing.
Frequently Asked Questions
Can You Take Money out of a CD Early?
If necessary, depositors can access funds from a CD before maturity by accepting a penalty. It’s advisable to assess liquidity needs before committing to a long-term CD.
How Long Does a CD Take to Mature?
The maturity period of a CD varies from a month to several years, influencing the interest rate. Longer terms typically yield higher returns, aligning with the principle of risk and reward.
What Happens When a CD’s Term Ends?
Upon maturity, depositors have options to cash out, transfer funds, or reinvest in a new CD. Communication with the financial institution is crucial to avoid automatic rollovers into a new CD.
Is the Interest on a CD Taxable?
Unless held in a tax-advantaged account, CD interest is subject to taxation. Understanding the tax implications based on account type, like traditional and Roth IRAs, is essential for effective financial planning.
The Bottom Line
Certificates of deposit have stood the test of time and continue to be a favored investment vehicle for individuals, institutions, and governments, offering a secure means of earning enhanced interest on savings.