A term deposit, also known as a certificate of deposit (CD) or time deposit, is a low-risk, interest-bearing savings account. In most cases, term deposit holders place their funds into an account with a bank or financial institution and agree not to withdraw the funds until the maturity date (the end of the term). The funds can earn interest calculated based on the amount deposited and the term.
This guide explains what a term deposit is in more detail, including:
• How term deposits work
• What a time deposit is
• Different types of term deposits
• How to open and close a term deposit
• The pros and cons of terms deposits.
What Is a Term Deposit or Time Deposit?
Time deposit, term deposit, or certificate of deposit (CD) are all words that refer to a particular kind of deposit account. It’s an amount of money paid into a savings account with a bank or other financial institution. The principal can earn interest over a period that can vary from a month to years. There is usually a minimum amount for the deposit, and the earned interest and principal are paid when the term ends.
One factor to consider is that the account holder usually agrees not to withdraw the funds before the term is over. However, if they do, the bank will likely charge a penalty. Yes, that’s a downside, but consider the overall picture: Term deposits typically offer higher interest rates than other savings accounts where the account holder can withdraw money at any time without penalties.
Compared to stocks and other alternative investments, term deposits are considered low-risk (they’re typically insured by the FDIC or NCUA), and the returns are correspondingly conservative.
How Does a Bank Use Term Deposits?
Banks and financial institutions can make money through financing. For example, they likely earn a profit by issuing home, car, and personal loans and charging interest on those financial products. Thus, banks are often in need of capital to fund the loans. Term deposits can provide locked-in capital for lending institutions.
Here’s how many bank accounts work: When a customer places funds in a term deposit, it’s similar to a loan to the bank. The bank will hold the funds for a set time and can use them to invest elsewhere to make a return. Let’s say the bank gives the initial depositor a return of 2% for the use of funds in a term deposit. The bank can then use the money on deposit for a loan to a customer, charging a 6% interest rate for a net margin of 4%. Term deposits can help keep their financial operation running.
Banks want to maximize their net interest margin (net return) by offering lower interest for term deposits and charging high interest rates for loans. However, borrowers may choose a lender with the lowest interest rate, while CD account holders probably seek the highest rate of return. This dynamic keeps banks competitive.
Recommended: Breaking Down the Different Types of Bank Accounts
How Interest Rates Affect Term Deposits
Term deposits and saving accounts in general tend to be popular when interest rates are high. That’s because account holders can earn a high return just by stashing their money with a financial institution. When market interest rates are low, though, people are more inclined to borrow money and spend on items like homes and cars. They may know they’ll pay less interest on loans, keeping their monthly costs in check. This can stimulate the economy.
When interest rates are low (as checking account interest rates typically are), the demand for term deposits usually decreases because there are alternative investments that pay a higher return. For example, stocks, real estate, precious metals, or cryptocurrency might seem more appealing, although these are also higher risk.
The interest rate paid on a term deposit usually depends on the amount deposited and the time until maturity. So, a CD of $10,000 with a maturity date of six months might pay 0.05% annual percentage yield (APY), while a certificate of deposit of $10,000 with a maturity date of five years might pay 0.15% APY. Also, if you have a larger deposit with which to open a CD, you will likely have more options; these may include higher APY earning.
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Types of Term Deposits
There are two main types of term deposits: fixed deposits and recurring deposits. Here’s a closer look.
Fixed deposits are a one-time deposit into a savings account. The funds cannot be accessed until the maturity date, and interest is paid only on maturity.
With a recurring deposit, the account holder deposits a set amount in regular intervals until the maturity date. For example, the account holder might deposit $100 monthly for five months. Each deposit will earn less interest than the previous installment because the bank holds it for a shorter period.
In addition to these two types, you may see banks promoting different kinds of CDs, whether they vary by term length or by features (such as penalty-free, meaning you aren’t charged if you withdraw funds early).
Opening a Term Deposit
To open a term deposit account, search online for the best interest rates, keeping in mind how much you want to deposit, how often, and for how long. Most banks will ask you to fill in an online application. Make sure you read and agree to the terms of the agreement. For example, check the penalties that apply if you decide to withdraw your funds early as well as the minimum amount required to earn a certain interest rate.
Closing a Term Deposit
A term deposit may close for two reasons — either the account reaches maturity or the account holder decides to end the term early. Each bank or financial institution will have different policies regarding the penalties imposed for breaking a term deposit. Read the fine print or ask a bank representative for full details.
When time deposit accounts mature, some banks automatically renew them (you may hear this worded as “rolled over” into a new account) at the current interest rate. It would be your choice to let that move ahead or indicate to the bank that you prefer to withdraw your money.
If you want to close a term deposit before the maturity date, contact your bank, and find out what you need to do and the penalties. The penalty will depend on the amount saved, the interest rate, and the term. The fee may involve the loss of some or all of interest earned.
Term Deposits and Inflation
Term deposits may not keep up with inflation. That is, if you lock into an account and interest rates rise over time, your money won’t earn more. You will likely still earn the same amount promised when you funded the account. Also, once tax is deducted from the interest income, returns on a fixed deposit may fall below the rate of inflation. So, while term deposits are safe investments, the interest earned can wind up being negligible. You might investigate whether high-yield accounts or stocks, for instance, are a better option.
Term Deposit Pros
What are a term deposit’s advantages versus regular high yield bank account and other investments? Here are some important benefits:
• Term deposit accounts are low-risk.
• CDs or time deposits usually pay a fixed rate of return higher than regular savings accounts.
• The funds in a CD or deposit account are typically FDIC-insured.
• Opening several accounts with different maturity dates can allow the account holder to withdraw funds at intervals over time, accessing money without paying any penalties. This system is called laddering.
• Minimum deposit amounts are often low.
Term Deposit Cons
There are a few important disadvantages of term deposit accounts to note, including:
• Term deposits can offer lower returns than other, riskier investments.
• Term deposits and CDs usually have fixed interest rates that do not keep up with inflation.
• Account holders likely do not have access to funds for the length of the term.
• Account holders will usually pay a penalty to access funds before the maturity date.
• A term deposit could be locked in at a low interest rate at a time when interest rates are rising.
Examples of Bank Term Deposits
Here’s an example of how time deposits can shape up. Bank of America is the second-largest consumer bank in the United States, according to the Federal Reserve. As of May 2022, the bank offered a Standard Term CD account and a Featured CD account.
• The Standard Term CD: A 12-month CD with a minimum deposit of $1,000 pays 0.03%.
• The Featured CD: A 12-month Featured CD with a minimum deposit of $10,000 pays 0.05%.
As you see, the premium account, with a significantly higher minimum deposit, earns almost twice as much interest as the regular version. Still, neither earns what might be deemed a high rate.
Recommended: How Do You Calculate Interest on a Savings Account?
Term deposits, time deposits, or CDs are conservative ways to save. Account holders place a minimum amount of money into a bank account for a set term at a fixed interest rate.
The principal and interest earned can be withdrawn at maturity or rolled over into another account. If funds are withdrawn early, however, a penalty will likely be assessed.
While these accounts typically have a low interest rate, they may earn more than standard bank accounts. What’s more, their low-risk status can help some people reach their financial goals.
If you’re looking for security plus a great interest rate, see what SoFi offers. When opened with direct deposit, our Checking and Savings pays 1.50% APY, which is 41 times the current national average checking account rate. What’s more, we don’t charge any fees, so your money can grow faster.
Can you lose money in a term deposit?
Most term deposits or CDs are FDIC-insured, which means your money is safe should the bank fail. However, if you withdraw funds early, you may have to pay a penalty. In a worst-case scenario, this could mean that you receive less money than you originally invested.
Are term deposits and fixed deposits the same?
There is usually no difference between a term deposit and a fixed deposit. They both describe low-risk, interest-bearing savings accounts with maturity dates.
Do you pay tax on term deposits?
With the exception of CDs put in an IRA, any earnings on term deposits or CDs are usually subject to federal and state income taxes. The percentage depends on your overall income and tax bracket. If penalties are paid due to early withdrawal of funds, these can probably be deducted from taxes if the CD or term deposit was purchased through a tax-advantaged individual retirement account (IRA) or 401(k).
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