What is a Certificate of Deposit and Its Types?

A certificate of deposit or CD is a type of savings account. This type of account holds a fixed amount of money for a fixed time period. This time period may vary from six months to five years. In exchange for this, the issuing bank will pay interest along with invested money when you either cash in or redeem the certificate of deposit.

Table of Contents

• What is a Certificate of Deposit?
• Types of Certificate of Deposits
• Jumbo CD
• Traditional CD
• CD Specials
• Brokered CD
• IRA CD
• Step-Up CD
• Callable CD
• Bottom Line CD
• Why Do We Need a Certificate of Deposit?
• Important Terms You Agree To While Opening a CD
• Certificate of Deposit Vs. Savings Account
• Taxation on Certificate of Deposits in India
• Limitations of Investing In Certifcate of Deposit

What is a Certificate of Deposit?

A certificate of deposit (CD) is a type of savings product through which the investor earns interest on the amount for a fixed time period. This amount is fixed since the money is locked in else the investor will have to pay a penalty. Since the liquidity is lost, the certificate of deposit has a higher rate of interest. There is less opportunity for growth since it is a non-volatile investment mode. However, it guarantees a rate of return. 

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Types of Certificate of Deposits

1. Jumbo CD

• Features: This certificate of deposit requires a minimum deposit of usually ₹100,000 or more.
• Please Note: Ideal for investors with significant savings looking for a secure place with higher interest rates. The large deposit requirement, however, limits accessibility for the average saver.

2. Traditional CD

• Features: It offers a fixed interest rate over a specified term. This can range from a few months to several years.
• Please Note: A solid choice for those seeking a straightforward, low-risk investment. The main drawback is the penalty for early withdrawal, which can eat into the interest earned or even the principal amount.

3. CD Specials

• Features: This is a promotional CD that banks offer for a limited time. It often provides higher interest rates or comes with unique terms.
• Please Note: This type of CD can provide an excellent opportunity to lock in a higher rate, but it's important to review the terms closely, as there may be specific conditions or higher minimum deposits required.

4. Brokered CD

• Features: Sold through brokerage firms, allowing access to CDs from various banks in one place.
• Please Note: Offers the convenience of shopping around for the best rates and terms. However, it may come with additional fees, and the process of reclaiming funds if a bank fails can be more complicated compared to direct bank CDs.

5. IRA CD

• Features: A CD held within an Individual Retirement Account, combining the tax advantages of an IRA with the fixed returns of a CD.
• Please Note: Suitable for retirement savers looking for guaranteed returns. Keep in mind the restrictions and potential penalties for early withdrawal from an IRA.

6. Step-Up CD

• Features: The interest rate increases at predetermined intervals throughout the CD's term.
• Please Note: Attractive for those anticipating rising interest rates, allowing savers to benefit without committing to a long-term rate. Initial interest rates may be lower than those of traditional CDs.

7. Callable CD

• Features: It gives the issuing bank the right to terminate the CD before its maturity date. This is usually in exchange for a higher interest rate.
• Please Note: While the potential for higher returns is appealing, there's a risk the bank may "call" the CD during periods of falling interest rates, leaving investors to reinvest at lower rates.

8. Bottom Line CD

• Features: This is not an actual CD type but a way to think about what is most important when picking any CD. It combines looking at how much interest you'll earn, how long you agree to keep your money in the CD if you can get to your money early, and what you're saving for.
• Please Note: When thinking about the "Bottom Line CD," keep these points in mind:
  • Matching Your Goals: Pick a CD that fits what you're saving for, whether it is something soon or way in the future.
  • Weighing Risk vs. Reward: Think about if you're okay with the chance of earning more interest with some risks, like paying a fee if you take your money out early.
  • Knowing When You Need Your Money: Decide how important it is to be able to use your money before the CD is up. Choose a CD that gives you the right mix of a good interest rate and the chance to use your money if you really need it.

Why Do We Need a Certificate of Deposit?

Imagine you have been saving up money from birthday gifts, allowances, and maybe a part-time job. You have got ₹1,000 and want to make sure this money grows over time instead of just sitting in a piggy bank or a regular savings account where it earns very little interest. Here is where a Certificate of Deposit (CD) comes into play.

Let us say you decide to put your ₹1,000 into a CD with a 1-year term and a 2% interest rate. This means you agree not to touch this money for a whole year. In return, the bank will pay you 2% of ₹1,000, which is ₹ 20, at the end of the year. So, you'll have ₹1,020 without doing anything extra. 

Here is what will happen when you invest in a certificate of deposit:

1. More Money: CDs typically offer higher interest rates as compared to regular savings accounts. Due to this, your money grows more.
2. Safe and Secure: Your money in a CD is protected up to certain limits, making it a safe place to keep your savings.
3. Learning Discipline: Since you agree not to use your money for a while, it teaches you to plan and save for the future.

Important Terms You Agree To While Opening a CD

While opening a certificate of deposit, one agrees to the following:

1. Principal amount: The amount is agreed upon and is invested in a certificate of deposit. This amount cannot be withdrawn without paying a penalty.
2. Organization: You also agree to the financial institution where you will invest your money. This institution will be responsible for determining the terms of the agreement including early withdrawal penalties.
3. Term: The time period for which you will fix the amount is also confirmed. It may vary from 6 months, 1 year, 18 months to even 5 years. Once the maturity date arrives, the term gets completed. At the maturity date, you can withdraw principal and interest without paying a penalty.
4. Interest rate: This is a fixed percentage that you are not allowed to change once you start the CD. Due to this fixed interest rate, there are both advantages and disadvantages to the investor. If the rate of interest on CD goes up after lock-in, then you will not get the interest at this rate. Similarly, if the interest rate on the certificate of deposit goes down, it will still not benefit the person.

Certificate of Deposit vs Type of Savings Account

A Certificate of Deposit is a type of savings account. However, it still differs from other types of savings accounts in the following way:

Taxation on Certificate of Deposits in India

In India, the taxation of CDs depends on various factors such as:

1. Type of CD:

• • Interest earned on regular CDs is considered income from other sources and will be taxed according to income tax slab.
  • You are allowed to claim a deduction of upto Rs. 10,000 in a financial year as per Section 80TTA of the Income Tax Act, 1961.
  • If the interest income on a regular CD exceeds Rs.10,000 within a financial year, the bank will deduct TDS at 10% (or applicable rate based on your tax status).
  • These offer lower interest rates but provide a deduction as per Section 80C of the Income Tax Act.
  • Rs.1.5 lakh is the maximum deduction in a year.
  • No TDS is deducted on tax-saving CDs.

2. Investment period:

• • Less than 1 year: If you hold the CD for less than 1 year, the earned interest will be added to your income and taxed according to your tax slab.
  • More than 1 year: If you hold the CD for more than 1 year, you have two options:
    • Tax on accrual basis: You pay tax on the interest earned every year, even if you have not received it yet.
    • Tax on receipt basis: You pay tax only when you receive the interest at maturity or on renewal. This option is available for individuals below 60 years old.

3. For Senior Citizens:

• Senior citizens (over 60 years old) get additional tax benefits on interest earned on CDs.
• They have a higher deduction limit under Section 80TTA (Rs.50,000) and a lower TDS rate (7.5%).

Limitations of Investing In Certifcate of Deposit

The following points highlight the limitations of investing in Certificate of Deposit:

1. While CDs offer guaranteed returns, they provide lower yields compared to stocks, bonds, or real estate. The returns cannot compensate for inflation which lead to reduced purchasing power over time.
2. Early withdrawal penalties can lead to a loss in several months of earned interest or even part of your principal. This makes CDs unsuitable for emergency funds or when you need quick access to your money.
3. If market interest rates rise after the CD rate has been locked, the investor will be stuck with the lower rate until maturity. This opportunity cost means missing out on potentially higher returns available in the market.
4. The lock in period means you cannot leverage better investment opportunities that may arise during the CD's term without paying penalties.
5. Interest earned is taxed as ordinary income, even if the investor does not withdraw it. This can result in higher tax liability compared to investments that qualify for preferential tax treatment like long-term capital gains.
6. Many banks require substantial minimum deposits for their best CD rates. This makes it difficult for smaller investors to access the most competitive returns.
7. During periods of high inflation, the fixed return from CDs may not maintain your purchasing power, resulting in negative real returns when adjusted for inflation.

Unlike stocks or real estate, CDs do not offer the potential for capital appreciation. Your return is limited to the stated interest rate, regardless of market conditions. When the CD matures, investors may have to reinvest at lower rates if interest rates have declined. Therefore, it is important to consider both pros and cons before investing in Certificate of Deposits.

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