How Do Bank CDs Work?
Understand how a Certificate of Deposit (CD) works before comparing interest rates online or buying one at your bank.
Rules and Regulations of Bank CDs
Certificates of deposit, commonly known as bank certificates of deposit or CDs, are issued by many financial institutions. CDs are regulated by federal and state banking regulators. Besides the convenience of simply transferring funds from your checking account to purchase a CD, they also provide a high degree of safety. Rates paid on CDs are regulated under Regulation T of the Federal Reserve System, which prescribes how the banking community may offer CDs and how they count toward meeting the bank's reserve requirements.
Federally insured bank CDs can be offered by a thrift or banking institution or credit union. They may be purchased online as well as through your broker, and kept in your brokerage account. CDs may be written for maturities ranging from a few months to several years, depending on the bank's funding needs. CDs are guaranteed by the Federal Deposit Insurance Corporation (FDIC) up to certain limits.
How a Bank Certificate of Deposit Works
Buying a CD is much like purchasing a bond. Paperwork is minimal and can be completed online. The CD will have a maturity and a coupon rate. Purchasers have the choice of receiving dividends or having dividends reinvested and paid at maturity. Banks advertise CDs based on the annual percentage rate (APR). APR assumes all dividends are reinvested to maturity. You should buy a CD based on the highest APR, not the advertised coupon. You also should take care to understand how the insurance feature works. Insurance limits vary and have temporarily been raised to $250,000, which includes all principal and interest paid. The normal rate of insurance provided is $100,000. Investors may open several accounts to write additional CDs. Any bank executive will be glad to assist you. If you need to redeem the CD before the maturity date, there will be a penalty imposed.
Banks consider the CD as an important mainstay of its required reserves. Bank CDs pay higher rates than savings accounts, but they can count on most CDs remaining until maturity. Bank CDs are then loaned out by the bank to borrowers. The bank keeps the spread, or difference, between its cost of funds and the lending rate, for its gross profit.
Varieties of Certificates of Deposits
In recent years, banks have expanded the variety and terms of bank CDs in order to better compete with customer needs and to attract funds for the bank. Banks offer variable rate CDs, which reset periodically. Individuals can purchase CDs denominated in foreign currencies or CDs representing a basket of currencies. Individuals must be aware that some certificates are callable, meaning that the CD may be subject to an immediate drop in rate if market interest rates decline. Also, if a CD matures, the investor normally has several days to reinvest the proceeds or the bank will reinvest the amount as a very short-term CD at a low interest rate.
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