A certificate of deposit is a type of fixed-income instrument issued by scheduled commercial banks. These instruments come under the regulation and governance of the Reserve Bank of India. It entails investors to park their funds for a fixed tenure and earn interest on them. The scheduled commercial banks issue certificates of deposits in a dematerialized form. Certificates of deposits are issued by banks at a discount based on the face value.
On the completion of the investment tenure, depositors receive the full principal amount along with the compounded interest earned on the principal amount. A certificate of deposit (CD) signifies in writing that the individual has deposited a certain amount for a fixed term, and he will receive the principal amount along with interest on maturity.
What is the Meaning of Certificate of Deposit?
It is a fixed-term financial instrument issued by banks under the guidelines mandated by the Reserve Bank of India. It offers a higher interest rate than a savings account but scores lower on the liquidity front as compared to the savings account.
If you have invested your money in a certificate of deposit, it gets locked in for the specified time period. It means that you cannot withdraw the money before maturity. Doing so would incur very high premature withdrawal charges.
All aspects of a certificate of deposit, like tenure, minimum amount, premature withdrawal penalty and interest rates, vary from one bank to another. Investors can either visit the bank’s webpage or physical premises to get all the required information.
Now that you have understood the certificate of deposit meaning, let’s shift our attention to other aspects like features, eligibility and benefits.
Types of Certificates of Deposits
Different kinds of certificates of deposits are as follows:
- Traditional Certificate of Deposits
This is the regular CD which has a fixed interest rate and strict penalties on early withdrawals. It functions similarly to fixed deposits.
- Bump-Up Certificate of Deposits
Under this type of CD, there is an option of raising the interest rate during the tenure if the market CD interest rate increases. Generally, the initial interest rate of Bump-up CDs is lower than normal CDs. The interest rate will increase only with the consent of the investor.
- Step-Up Certificate of Deposits
It is similar to bump-up CDs, which offer the possibility to raise interest rates midway through the investment tenure. However, unlike bump-up CDs, in step-up CDs, the issuing entity can raise the interest rate on its own without being instructed by depositors.
Features of Certificate of Deposit
Some notable features of certificates of deposit are as follows:
- Minimum Amount
The minimum amount that one can deposit in a certificate of deposit is ₹1,00,000. However, it is better to get in touch with the banks to know the minimum amount, as it can differ.
- Tenure
Certificates of deposit come with different tenures. The tenure of a certificate of deposit can be as short as 3 months and as long as 3 years. Banks can issue a certificate of deposit for a tenure between 3 months and one year. Whereas other financial institutions can issue a CD having a tenure of 1-3 years. Upon the completion of the tenure, one can withdraw their funds along with compounded interest without any penalty.
- Interest Rates
Banks and other financial institutions offer a fixed interest rate to the depositors. It means that the maturity payout, which includes the principal and interest component, is pre-fixed. Once an individual buys the certificate of deposit, banks cannot change the pre-agreed interest rates.
- Negotiability
Banks and other financial institutions are not permitted to trade a certificate of deposit in secondary markets. Moreover, issuers cannot buy back the certificate of deposit before maturity.
Eligibility of Certificate of Deposit
Banks can issue certificates of deposits to individuals, corporations, companies and funds under the aegis of Reserve Bank of India guidelines. NRIs can also invest in certificates of deposit but only on a non-repatriable basis. Banks must maintain a proper statutory liquidity ratio and cash reserve ratio equivalent to the price of certificate of deposit issued.
Benefits of the Certificate of Deposit
Some major benefits of a certificate of deposit are as follows:
- Low Maintenance Costs
There is no maintenance cost involved in certificates of deposit. Unlike stock market trading, which involves brokerage charges, fees, settlement charges, etc., and mutual fund investments which have an expense ratio, CDs do not come with any additional cost.
- Higher Interest than Savings Account
Certificates of deposit provide a higher interest rate than a savings account. The interest rate of savings accounts hovers between 4-4.5%, whereas the rate of interest in CDs can be between 7-8%.
- Security
One of the biggest advantages of a certificate of deposit is the security that it provides to depositors. It is an ideal investment avenue for conservative investors who are looking for moderate returns at minimal risk. Investors will witness continuous increases in the value of their investments without any chances of loss.
- Flexibility
A certificate of deposit is quite flexible in its operation. Depositors can opt for payouts on either a monthly or quarterly basis. They can also opt for a lump sum payment at the time of maturity. Investors can decide on the investment horizon as well as the amount that they wish to invest. In simple words, they can customize this investment to suit their requirements.
How to Choose a Certificate of Deposit?
Usually, a certificate of deposit has a direct relationship with prevailing market interest rates and investment tenure. The longer the investment tenure, the higher will be the interest rates offered by banks and other financial institutions. Here are some things that one can consider while deciding to invest their money in a certificate of deposit:
- First, the investor must decide for how long they can keep their money locked in. After determining the time period, they can scout for CDs offered by various banks and choose the one offering the highest rate within the specified timeline.
- If investors think that there will be an increase in interest rates in the future, they can choose a shorter time span. In doing so, they can renew the CD at a higher interest rate later on.
- In case the investor thinks that the interest rate will fall in the near future, they can invest for a longer duration to keep the funds locked in at a better rate of interest.
Example of Certificate of Deposit
Let’s consider an example of a certificate of deposit to understand how it works:
Mr. Wasim has decided to invest ₹5,00,00 in a certificate of deposit for 2 years at 8% per annum interest rate compounded annually. He has opted to receive the full amount at maturity only. Hence, the amount that he will receive after two years will be ₹5,83,200. Within this, ₹5,00,000 is the principal amount, and the remaining ₹83,200 is the interest earned on the same.
What is the Difference between Commercial Paper and Certificate of Deposit?
A certificate of deposit can be issued by banks and other financial institutions. However, commercial paper can only be issued by primary dealers and large corporations. The minimum amount in case of a CD is ₹1,00,000, whereas the minimum investment amount in commercial paper is ₹5,00,000.
Summing Up
The certificate of deposit is a popular investment mechanism which provides moderate interest income at nil or zero risk. This can be an ideal investment option for conservative and risk-averse investors or those who don’t know about secondary market functioning. However, if one is looking to invest money in a CD, they should analyse their investment objective and various products offered by banks before making any decision.